An Evaluation of Funds to Businesses by Commercial Banks Finance Essay

Introduction

The growth of businesses is noted to be one of the main factors behind economic development of many countries. The success of business sectors especially small and medium sized enterprises (SME) has positive impact on the economic development of most countries, more notably in the developing countries. Business sectors including SME do not only help economic growth through employment opportunities and revenue to governments in the form of taxes and but also promote poverty alleviation through their support in community projects in and around the communities in which they operate. In 2005, United Nation Economic Commission of Africa annual report indicated that over 90% of businesses in many African countries are made up of SME and Informal sectors which account for 63% of low income employment and over 50% GDP. However, lack of adequate access to finance in most developing and emerging markets place huge obstacle to the survival and growth of businesses and thereby slow down economic development. Most of these businesses do not survive or are forced to cut back their operations due to lack of external finance. While big firms may be able to generate funds through stock markets and debt finance from most banks, access to funds by SME are very much limited, in many cases to owners' and family members' savings and small sized commercial banks.

Contrary to the common perceptions, usually supported by academics and policy cycles, that many businesses especially small and medium size cannot have access to appropriate source of finance, many research works in developed economic countries indicate otherwise. Some of the works indicated that some financial institutions notably commercial banks have found lending to businesses including small and medium sized enterprises (SME) profitable. A recent research found that about 80% of the banks investigated were involved in most businesses including SME, with 60% of them having separate departments to deal SME (Berk et al, 2008). According to Schmuler et al, banks are changing their organizational set-up to approach and serve this segment efficiently (Schmuler et al; PricewaterhouseCoopers, 2003. De la Torre et al. (2008) also found in their work that most of the banks use different transactional technologies such as credit score and standardized risk rating tools that enhance arm-length lending to serve businesses, thus reducing their dependence on expensive methods such as relationship lending which involved gathering of "soft" information by the loan officer through continuous, personalized, direct contacts with SMEs. However the transformation of banks' perception towards businesses is not worldwide, as the situation in most developing such Pakistan remained much unchanged. United Nations Environment Programme Finance Initiative (UNEP FI) African Task Force (ATF) as part of its mandate to support sustainable financial practice in Africa, commissioned a research through discussions with experts and gathering of case-studies and research and reported that most banks in Africa perceived SME as risky, unprofitable and lack skills and capacity to run successful business. Entrepreneurs also perceived stake in their business as giving away to outsider and the cost of doing business with the banks as high.

These factors contributed to business lending constrained in many African countries. Other empirical research carried out in on other countries also established many varying factors affecting accessibility of credit to businesses. An analysis of database of securitisation activities among many European banks by Altunbas et al concluded that the increased in securitisation had affected the banks' ability to grant loans, though they were quick to emphasise that the recent credit crisis played part (Altunbas et al, 2009). Atanasova and Wilson, 2004) investigated the impact of monetary transmission mechanism on the availability of bank credit to SME in UK and concluded that a period of tighten monetary conditions negatively influenced the supply of bank loans to businesses and firms asset as collateral play important role in bank credits. This confirmed the work of (Kashyap et al, 1993) who suggested that tight monetary policy reduces the supply of bank credit and borrowers are forced to turn to the use of commercial paper. Collateral requirements (Berger and Udell,1990: Atanasova and Wilson,2004), borrower's relationship with the banks (Petersen and Rajan,1994:Berger and Udell ,1995) and banks' size (Peek and Rosengren,1996: Bergeret el al,1998: Uchida et al,2008) have all been found to impact on the accessibility and the cost of banks loans to businesses, especially SMEs. Evidence from Peek and Rosengren, Bergeret et al and Uchida et al suggested that large banks tend to reduce lending to smaller businesses or favour lending to larger firms because of lack of transparency of small business information. The Carter and MCnulty (2005) reported otherwise, that larger banks are making in-road in the market for SMEs loans due to increase in use of credit scoring facilities which . Eventhough the above mentioned factors have been identified to impact on supply of banks credit to businesses, macroeconomic condition of a country can be the key factor that impact on banks' ability to meet the financial need of many businesses. Developed economies are known to have financial institutions that are well capitalised with better access to their supply of funds due to favourable economic conditions. Deposits and savings from individuals and organisations are the main sources of funds to commercial banks. These individuals and organisations lodge excess of their net disposal incomes with banks with which the banks are able to carry out their services as intermediaries. These net disposable incomes are however affected by macroeconomic factors in the country. The better these factors are, the higher supply of funds to banks would be and hence high level of loanable funds.

Nature of problem to be investigated

While many empirical research had been done to identify factors that influence banks credit to businesses and the banks' lending behaviour, most of these works have been carried out in countries whose economy, political situations and social environment are different from those developing countries such as Pakistan. Many governments of Pakistan have undertaken different programmes in the country aimed to meeting the financial needs of business sectors. For instance, in 1988, the government of Pakistan initiated a programme called Financial Sector Adjustment programme (FINSAP). This was launched to address the deterioration in the financial sector which is had been characterised by years of mismanagement and government interference in the administration of credit, with most banks rendered technically insolvent. FINSAP, as a financial sector liberalization programme was to help restore fiscal and monetary discipline into the sector and also to remove government control and restrictions so as to improve efficiency in the financial sector (Asamoah, 2008). The main aims of the programme were to restructure the financial industry to allow competition and improve the banks resource mobilisation that would increase credit availability in the country. Though the banking sector has since then seen some growth, yet their credits extension to businesses have not been as expected. Economic instability experience in the country is continuously blamed for this. It is for this reason that I find it necessary to research into how Pakistan's macroeconomic variables affect business lending practices of commercial banks in Pakistan, with a focus on Pakistan Commercial banks.

Research Objectives

This study is being carried out to identify factors that affect or influence Pakistan Commercial bank lending practices to businesses, including SME in Pakistan. The main objectives of this study are: To assess how Pakistan's macroeconomic variables impact on Pakistan commercial bank's lending to businesses. To ascertain other factors that banks take into account when they lend to businesses, with focus on Pakistan commercial bank.

 Research Approach

The approach I have adopted to this study involves collection and analysis of both primary and secondary data. I have used both quantitative and qualitative method of analysis to achieve my research objectives. Summary of Data Used: The primary data used in this study are responses to questionnaire completed by the appropriate loan Officers of Pakistan Commercial bank at different branches. The secondary data involve sample of Pakistan Commercial bank' previous loans to various businesses in Pakistan together with some macroeconomic variables existed at the time of the loans. This economic variable used interest rates, inflations and exchange rates.

layout of written work

This section is about a summary of the contents of this study's report. Chapter one shall focus on the overview of the research question, objectives of the report, and a design of the research work The next chapter of this study report is chapter two, LITERATURE REVIEW. This part of the report contains theoretical works covering how the above mentioned macroeconomic variables influence banks including Pakistan Commercial banks lending behaviour. The literature is extended to detail how non-economic factors such as the personal relationship between the banks' staff and the owners or management of the banks business customers help in the banks' lending decisions. It also laid out the impact of collateral on the loan terms. Most of the sections under this chapter also contain various empirical research findings relating to business lending by banks in many different countries. Chapter three is on METHODOLOGY. This chapter contains sections on methods of obtaining the various data used in this study, the sampling methods adopted in this study, the business models in the study and how I analysed the data obtained to arrive at my conclusion. Chapter Four is the RESULTS AND DISCUSSIONS. This part of the report contains the outcome of the regression equations estimated by the regression software and their respective interpretations. It also contains deductions made from responses to the questionnaire. Chapter Five is the CONCLUSION I drawn from the study and my recommendation for future improvement.

Literature review

Introduction and chapter overview

The main objective of financial institutions and for that matter Pakistan Commercial Bank is to make profit and maximize the wealth of their investors and shareholders through reinvestment of the premiums, deposits or funds generated. These reinvestments take the form of tangible asset management such as land and buildings, stake in other organizations, purchase of government bonds and lending to individuals and businesses.

 the ultimate lenders and ultimate borrowers

Ultimate lenders are described as the agents whose excess of income over expenditure creates financial surplus which they are willing to lend and make returns. Ultimate borrowers are those whose excess expenditure over their income creates a financial deficit which they wish to meet by borrowing (Howell and Bain, 2000). Ultimate borrowers include individuals and businesses and governments.

 financial institutions

The financial needs of different organisations and individual vary widely. Financial institutions are the different types of firms that act as intermediaries in meeting the various financial needs of these different organisations and individuals (Miller and Vanhoose, 2001). Financial institutions are private and public organizations which act as channels between the savers and borrowers. They provide the mechanism for transferring funds from savers to borrowers. Financial institutions could be distinguished from each other in different ways. The common mode is by their products and services. The two main distinguishing are the deposit taking institutions (DTI) and non-deposit taking institutions (NDTI). NDTI are organizations such as insurance companies, pension funds Unit trusts and Investment trusts etc who create liabilities by the promises to pay funds to their savers on the occurrences of specified events. Until such specified events occur NDTI barely make payment on the supplied funds. Depository institutions (DTI) are dominants of all intermediaries. They accept deposits from ultimate lenders to provide credit to deficit units through loans and purchase of securities. Depository institutions open deposit accounts to accommodate the surplus units and repackage the funds received to borrowers in the form of loans and bonds. To compensate for the risk taken by DTIs in providing the loans, interest rates higher than the rates paid on the deposits are charged on the amount lent to the borrowers. Depository institution is made of two main categories, thrift institutions and commercial banks, which Pakistan Commercial bank, the subject of the research belongs to (Madura,2001).

Business lending by commercial Banks: Theoretical Framework

Business lending or commercial loan as commonly known may be described as loan advanced to businesses rather than consumers by financial institutions such as commercial banks. Commercial banks in acting as intermediaries take deposits from those with excess income and lend it out to businesses to meet their financial needs. To guarantee to depositors the security of their money and any returns, banks issues their funds to borrowers in the form of loans to generate income so that they repay depositors with interest. Businesses that borrow from the banks use the loan to satisfy their varying needs and are expected to pay back the loan within the period agreed with the bank and as specified in the term and conditions of the loan. The agreed period could be short-term (up to one year), medium-term (1 year to 5 year) and long-term (over 5 years). In order for banks to attract more depositors, the banks pay interest on the deposits lodged with the banks. According to Rose (2000), loans provide banks with largest portion their operating revenue and also constitute the highest yielding asset. This assessment was confirmed by the work of Lloyds B Thomas Jr, 1986, who put it as 70% and 67 of operating income and assets respectively, work based on 1984 data. In the past, commercial lending was solely undertaken by banks but the perceived high profitability and increased competition in the financial industry had attracted non-banks institutions into lending (Fraser et al,1995). With increased in competition in financial industry and high profit margin associated with loans, one would expect businesses to access to finance with less difficulties. This has not been the case for many businesses, mostly SMEs. Many theoretical and empirical works have suggested many varying factors that affect and influence the accessibility of banks credits by businesses.

Business lending and Associated Risks

Any profit maximising business, such as banking involves risk. Credit risk or default risk has been identified as the main danger faced by banks in granting credit to borrowers. When extending credit to businesses, there is level of uncertain that the business might not pay back the credit taken. Credit risk is the risk that an asset or a loan may become irrecoverable in the case of outright default or delay in servicing the loan. Outright default and delays in servicing the loans reduce the present value to the asset/loan and consequently the solvency of the bank. High level of defaults by borrowers could result in liquidity problems for the banks. Customers deposit their money with the bank in the hope that they can withdraw the deposit when required (Herfferman, 2002). Failure on the part of the borrowers to pay back the loans could result in a situation where the banks will not have sufficient funds available for withdrawal when depositors need them. This could send wrong signal to depositors in respect to the security of their deposits and in a worse case, may result in bank run.

 

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