CHAPTER ONE
1.0 INTRODUCTION
1.1 Background to the Study
In a modern economic system, there is distinction between the surplus and deficit economic units and consequently a separation of the savings and investment mechanism. This has necessitated the existence of financial institutions whose jobs include the transfer of funds from savers to investors. One of the institutions is the money deposits bank, the intermediating roles of the money deposit banks place them in a position of “trustees” of the savings of the widely dispersed surplus economic units as well as the determinant of the rate and shape of the economic development. The techniques employed by banks in this intermediary function should provide them with perfect knowledge of the outcome of lending such that funds will be allocated to investment in which probability of full payment is certain. However, in practice no such tool can be found in the decision of lending bankers. Virtually all lending decisions are made under creditors uncertain of the risk and uncertainties associated with lending decision situations are so great that the concepts of risk and risk analysis need to be employed by lending bankers in order to facilitate sound financial decision making and judgment.
This statement implies that if risks are to be objective assessed, lending decisions by the money deposit banks should be based less on quantitative data and more on principals tools subjected to provide sound and unbiased judgment. Hence, the banks depend heavily on historical information as a basis for decision making. Apparently aware of the inadequacies of his or her decisions base, the lending banker has often sought solace in tangible and marketable assets as security giving the impression that lending against such securities is an insurance against bad debts. This makes the banker complacent with his loan port folio. The increasing trends of provision for bad and doubtful debts in most money deposit banks is a major source of concern not only to management but also to the shareholders who are be coming more ware of the dangers posed by these debts. Bad debts destroy part of the earning assets of banks such as loans and advances which have been described as the main source of earnings and also determine the liquidity and solvency which generates two major problems, that is liquidity and profitability, has to earn sufficient income to meet its operating costs and to have adequate returns on its investment. Lending has becoming a vital function in banking operations in view of its direct effect on the economic growth and development in the business sectors.
Thus, as far as banks are concerned, their activities are lending are as important as their deposit taking, considering the inter-relationships between lending and deposit taking. Although lending is risky, deposit money banks profit oriented organizations having a primary objective as profit maximization cannot do without lending out money. In most cases, they generate the highest proportion of their interest from lending. Moreso, the principal objective of lending of a bank is the provision of growth in profitability and liquidity within the economy. Deposit money banks play an important role in the pass-through of monetary interest rates. Nevertheless, the efficiency of transmission of decisions of Central Bank is a complicated process and may depend on many factors such as: level of competition in financial industry, perception of credit risk, risk aversion, availability of close substitutes for loans etc.
Moreover, banks may influence the external fiancé premium not only via the interest rate but also modifying the available maturity of loans or changing collateral requirements. Finally, as evidence by broad literature on bank lending channel, credit rationing and uncertainty about creditworthiness of borrowers may markedly influence banks risk taking thereby influencing their willingness to lend. The existence of bank lending channel is conditioned on two important assumptions. First, monetary policy decision impact on the bank liquidity position; second, changes in the supply of loans affect borrowers because of constrained access to other sources of financing than bank loans. Tightening of monetary policy usually leads to decrease in the demand of deposit because banks adjust their deposit rates only partially to the other sector to equity investment funds. Shrinking bank’s liabilities force banks to decrease the supply of loans accordingly.
