1.0. INTRODUCTION
In this note,
you shall learn broadly
speaking, about two major issues. These are the
principles of bank lending; and portfolio management. In the
principles of bank lending,
you shall get to know that these are the guiding principles for
banks in terms of
advancing loans to customers. The portfolio management on the
other hand has to do
with the day-to-day management of the total resources (wealth) of
the bank.
2.0. OBJECTIVES
At the end of this note, you should be able to;
· Describe the principles which banks follow in
terms of lending in the economy.
· List and explain each of the principles of bank
lending in an economy.
· Define and explain the concept of Portfolio
management
· State and explain the objectives of portfolio
management
3.0. PRINCIPLES OF BANK LENDING AND
PORTFOLIO MANAGEMENT
3.1. Principles of Bank Lending
Banks follows some principles in terms of lending in the economy.
These principles include
the following:
3.1.1. Liquidity principle
Liquidity is an important principle of bank lending. Banks lend
for short periods only
because they lend public money which can be withdrawn at any time
by depositors.
They, therefore, advance loans on the scarcity of such assets
which are easily
marketable and convertible into cash at a short notice. A bank
chooses such securities in
its investment portfolio which possess sufficient liquidity. It is
essential because if the
bank needs cash to meet the urgent requirements of its customers,
it should be in a
position to sell some of the securities at a very short notice
without disturbing their
market prices so much. There are certain securities such as
government bonds which are
easily salable without affecting their market prices. The shares
and debentures of large
industrial concerns also fall in this category. Therefore, banks
invest in government
securities, shares and debentures of reputable companies.
3.1.2. Principle of
profitability
This is the cardinal principle for making investment by banks. It
must earn sufficient
profits. Banks therefore, invest in such securities which assure a
fair and stable return on
the funds invested. The earning capacity of securities and shares
depends upon interest
rate and the dividend rate and the tax benefits they carry. Banks
normally invest in
securities that yields more returns than those that yield less
returns, all things being equal.
3.1.3. Principle of safety of
bank funds
The safety of funds lent is another principle of bank lending.
Safety means that the
borrower should be able to repay the loan and invest in time at
regular intervals without
default. The repayment of the loan depends upon the nature of
security, the character of
the borrower, his capacity to repay and his financial standing.
Like other investments,
bank investments involve risks. But the degree of risk varies with
the type of security.
Securities of Federal Government are said to be safer than those
of the state and local
governments. This is because the resources of the Federal
Governments are higher than
that of the state and local government resources. The banks always
take into
consideration the debt repaying ability of the governments while
investing in their
securities. Political stability, peace and security are
prerequisites for this. It is safer to
invest in the securities of a government having larger tax revenue
and high borrowing
capacity than in government securities with less tax revenue.
Above all, the safety of
bank funds depends upon the technical feasibility and economic
viability of the project
for which loan is advanced.
3.1.4. Principle of diversity
Commercial banks always follow the principle of diversity in
choosing its investment
portfolio. Banks invest their surplus funds in a particular type
of security but different
industries. They choose the shares and debentures of different
types of industries situated
in different regions of the country. Diversification aims at
minimizing risks of the
investment portfolio of banks. The principle of diversity also
applies to the advancing of
loans to varied types of firms, industries, businesses and trades.
These principles seek to
emphasize the fact that “keeping all eggs in one basket is
disastrous”. Banks need to
spread their risks by giving loans to various traders and
industries in different sectors of
the economy and different parts of the country.
3.1.5. Principle of stability
Another important principle of banks’ investment policy is
investment in those stocks and
securities which possess a high degree of stability in their
prices. The bank cannot afford
any loss on its securities. It should, therefore, invest its funds
in the share of reputable
companies where the possibility of decline in their prices is
remote. That is why banks
normally invest more in debentures and bonds which are more stable
than the shares of
companies.
3.2. Bank portfolio Management
The main aim of commercial banks is to seek profit like any other
institution.
Their capacity to earn profit depends upon their investments
policy. Their investment
policy, in turn, depends on the manner in which they manage their
investment portfolio.
Thus commercial banks investment policy emerges from a straight
forward application of
the theory of portfolio management to the particular circumstances
of commercial banks.
3.2.1. The Concept of Portfolio Management
Portfolio refers to the securities held by an investor or the
commercial paper held by a
bank or other financial institutions. It could be a group of
investments, asset of individual
equities, bonds and other marketable assets the investor owns.
Portfolio management
involves the principles and procedures by which to manage such
assets. Bank portfolio
management therefore, refers to the prudent, management of a
bank’s assets and
liabilities in order to seek some optimum combination of income or
profit, liability and
safety. In banking, the parts of a bank’s asset portfolio include
investments, liquidity,
reserves, and loans, and their management involves the total
balance sheet.
3.2.2. Objectives of Portfolio Management
There are three major objectives of portfolio management which
banks follow. These
include liquidity, safety and income or profit. These three
objectives are opposed to each other.
For examples, if the banks seek high profit, they may have to
sacrifice some safety and liquidity.
If they seek more safety and liquidity on the other hand, they may
have to give up some income
or profit. The main objectives of bank portfolio management are
discussed below.
3.2.2.1. Liquidity
A commercial bank needs a high degree of liquidity in its assets
which form one of the
cardinal objectives of its portfolio management. The liquidity of
an asset refers to the ease and
certainty with which it can be turned into cash. The liabilities
of a bank are payable on demand at
a short notice. Therefore, it must hold a sufficiently large
proportion of its assets in the form of
cash and liquid assets for the purpose of profitability. If the
bank keeps liquidity the upper most,
its profit will be low. On the other hand, if it ignores liquidity
and aims at earning more, it will
be disastrous for it. Thus, in managing its investments portfolio
a bank must strike a balance
between the objectives of liquidity and profitability. The balance
must be achieved with a
relatively high degree of safety. This is because banks are
subject to a number of restrictions that
limit the size of earning assets they can acquire.
3.2.2.2.Safety
Another objective of portfolio management by commercial banks is
to achieve safety in
their funds / assets. A commercial bank always operates under
conditions of uncertainty and
risks. It is uncertain about the amount and cost of funds it can
acquire and about its income in the
future. Moreover, it faces two types of risks. The first is the
market risk which results from the
decline in the prices of debt obligations when the market rate of
interest rises. The second is the
risk by default where the bank fears that the debtors are not
likely to repay the principal and pay
the interest in time. The risk is largely concentrated in customer
loans, where banks have a
special function to perform, and bank loans to business and bank
mortgage loans are among the
high-grade loans of these types. In the light of these risks,
commercial banks have to maintain
the safety of its assets.
3.2.2.3.Profitability
One of the principal objectives of portfolio management by a bank
is to earn more profit.
It is essential for the purpose of paying interest to depositors,
wages to the staff, dividend to
shareholders and meeting other expenses. It cannot afford to hold
a large amount of funds in cash
for that will mean foregoing income. But the conflict between
profitability and liquidity is not
very sharp. Liquidity and safety are primary considerations while
profitability is subsidiary, for
the very existence of a bank depends on the first two.
4.0. CONCLUSION
The note discusses the principle of bank lending and the
management of the portfolio of the bank
which are very cardinal to the successful management of a bank and
its profitability in the
economy. In specific terms the note recognizes liquidity,
profitability, safety, diversity and
stability among the banking lending principles while liquidity,
safety and profitability are
considered crucial objectives of portfolio management.
5.0. SUMMARY
In this note, we have learned about the principles of bank lending
and the portfolio
management of a bank. While the principles of bank lending guide
the lending
activities of the bank, the portfolio management helps the bank in
managing the
resources (portfolios) of the bank.
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