Lending is the process by which a financial institution provides funds to a borrower. Often called a lender, the institution typically receives interest in return for the loan. Lending in banking benefits lenders and borrowers alike by increasing liquidity within the marketplaces where loans are originated and used.
This makes it possible for businesses to borrow so they can expand their operations without having increased overheads from issuing new shares, thereby diluting equity positions held by earlier investors, or taking on expensive debt burdens that could push them into bankruptcy if there is even a modest downturn in economic conditions as we have experienced in recent years.
The benefits of lending in banking
The banking sector is one of the most important components of any economy and is a key driver of economic growth. One of the main functions that banks perform is providing loans to businesses and consumers, which help finance new investments and stimulate demand in the economy. The benefits associated with lending in banking are as follows:
- Increased economic growth - Banks play an important role in financing new business investment, leading to increased production and output, higher employment levels, greater innovation and more competitive companies. In addition, when consumers have access to credit, they can increase their spending on goods and services, boosting overall economic activity.
- More jobs - By providing credit facilities for businesses that are expanding or starting up operations, banks can create jobs that might not otherwise exist. Furthermore, bank lending helps foster a healthy business climate where firms are confident about investing in future expansion plans, knowing that there will be adequate funding available if needed. This contributes significantly to maintaining stable employment levels during tough periods such as in a recession.
- Improved access to credit - One major benefit of having well-functioning banks is improved access to debt instruments (loans).
- Reduced borrowing costs - Lower interest rates charged on loans by banks result in companies having more cash flow to reinvest back into their businesses, thereby stimulating economic growth. For consumers, it means they can borrow money at a lower cost to finance things like cars, homes and education.
- Improved economic stability - Finally, bank lending helps ensure an economy's overall stability since creditworthy firms can obtain the funding they need even during tough times. This prevents severe contractions or credit crunches from happening, which can lead to widespread layoffs and business failures.
Best practices for lending in banking
Banking is fundamental to a functioning economy. It enables the flow of money between savers and borrowers, allowing businesses to invest, grow and create jobs. Lending is, therefore, a critical part of the banking system, and banks must lend to support economic growth while also protecting against risks.
There are three key practices that are usually followed when lending:
- Careful credit risk assessment before approving loans
- Making conservative decisions when extending credit
- Close monitoring of loans
Assessing credit risk
Different borrowers pose different levels of risk for lenders. Before issuing a loan, banks need to assess the borrower’s creditworthiness by looking at their credit history, income level and debt-to-income ratio. This helps ensure that only those likely to repay their debts are granted credit, minimizing losses for the bank if the borrower defaults. By evaluating potential borrowers thoroughly, banks can avoid bad debt problems that hurt the bank’s balance sheet and the overall economy.
