Granting of credit is one of the fundamental and basic functions of banks. By their nature, banks intermediate between savers and users of funds – that is banks source funds from economic sectors with surplus funds in the form of deposits, and disburse the same to economic units that need them for various purposes in the form of credits or loans.
Apart from providing the fiduciary responsibility on depositor’s funds, granting of loans appears to be the next most important function of banks since this activity represents one of the key sources of income for banks. However, consideration of requests for loans, income or profit motivation does not and should not becloud the lending financial institution from ensuring that the loan, together with associated interest income, is repaid fully and timely. One of the surest ways of ensuring that credit, together with its related interest income, gets fully repaid is through a thorough credit analysis.
The importance of loan repayment on the part of a bank borrower cannot be over emphasized given the unsalutary consequences of loan default on a bank, given that it is depositors’ funds that a bank lends out if the borrower of such funds fails to pay back for whatever reasons it behooves the bank to repay the depositor(s) at the maturity of such deposits. A typical depositor would not be interested in learning the reasons why a bank would not pay its depositor at maturity of the deposit, in fact even a little delay in paying a depositor could trigger uncontrollable avalanche of requests for repayment of deposits by depositors. Even depositors whose placements had not matured could demand premature terminations and these could culminate in a run on the bank and eventual failure of the affected bank.
In order to prevent the above scenario, if a loan beneficiary defaults in loan repayment and the deposit with which the bank funded the particular loan matures the bank could be forced to pay the depositor from any of the following:
i) the bank’s shareholders funds (retained earnings) assuming such is sufficiently available (ii) source another deposit at whatever cost or
(iii) borrow inter-bank at whatever prevailing rate to repay the depositor.
The implication of option (i) above is the erosion of shareholders fund and attendant shrinkage of the bank’s balance sheet footing. The implication of the other two alternatives could also be disastrous for the bank as they could range from erosion of profit due to unplanned cost increase through undue reliance on inter-bank funding with its inherent uncertainties and high cost.