3. LENDING TO CUSTOMERS

1.Commercial banks lend money to their customers in the following ways:

(a)   by extending a direct loan in which the borrower's bank account is credited with the amount of the loan and interest is paid on the full loan.

(b)  by giving overdraft facilities to their customers who are able to withdraw more than the amount deposited in their current accounts after making prior arrangements with the bank. Interest is charged on the amount overdrawn.

(c)   by discounting bills for their customers. Bills are documents bearing the promise of either the government (i.e. Treasury bills) or well-known banking houses or persons of good credit standing (i.e. bills of exchange) to pay a stated sum of money at a stipulated date.

2. Banks purchase these bills from their customers at a discount on their face value. The discount is interest earned by the banks for holding the bills until maturity. The bank pays the holder of the discounted bill the amount stated less the interest on the sum for the number of days still to run before the due date.

3. Discounting bills is a kind of credit facility offered by the bank to its customers because the bank advances payment to a customer who has allowed his debtor a certain period of credit, and collects the debt from the debtor (i.e. the customer's debtor) when it falls due.

4. The commercial bank is able to carry out its lending activities for the following reasons:

(a) It knows from experience that only a small portion of its customers' deposits is                    withdrawn as cash at any one time; so it keeps a sufficient amount of cash to meet such withdrawals.

(b) It can use the rest of the deposits in the bank profitably by either investing or lending  them to customers. In fact, the commercial bank can lend out many times more than the cash deposited with it through multiple credit creation, subject to the limits imposed by the Central Bank with regard to the ratio of cash to total deposits.

(c) It pays interest to its depositors to encourage them to keep their money in the bank. The interest rate charged on loans and overdrafts will be higher so that the difference earned is used to pay for operating expenses and any residue becomes the bank's profits.