lending money (overdrafts, loans)

Money and Banking – Lending Money (Overdrafts & Loans)

1. Money – Definition, Functions & Characteristics

• Definition: Money is any asset that is widely accepted as a medium of exchange, a store of value and a unit of account.
• Three Functions
  • Medium of exchange – replaces barter and facilitates transactions.
  • Store of value – retains purchasing power over time (subject to inflation).
  • Unit of account – provides a common measure for pricing, accounting and comparison.
• Key Characteristics
  • Durability – does not wear out quickly.
  • Divisibility – can be broken into smaller units without loss of value.
  • Portability – easy to carry and transfer.
  • Fungibility – each unit is interchangeable with any other of the same denomination.
  • Acceptability – widely trusted and recognised by economic agents.

2. Money Supply & the Quantity Theory of Money

2.1 Monetary Aggregates (UK context)

Aggregate	What it includes
M0	Physical cash (notes & coins) in circulation.
M1	M0 + demand deposits (current accounts) + other highly liquid deposits.
M2	M1 + savings deposits + time deposits up to 2 years.
M3	M2 + longer‑term deposits, repos, and other liquid assets.

2.2 Quantity Theory of Money (MV = PT)

The equation links the money supply (M) to the price level (P), real output (T) and the velocity of money (V):

\[ MV = PT \]

• V – average number of times a unit of money is spent in a year.
• T – real national output (physical terms).
• Holding V and T constant, an increase in M leads proportionally to an increase in P (inflation).

Example: If V = 5, T = £200 bn and the Bank of England wants the price level unchanged (P = 1), the required money supply is

\[ M = \frac{PT}{V} = \frac{1 \times 200}{5} = £40\text{ bn} \]

3. Functions of Commercial Banks

• Accept deposits (current, savings, time).
• Provide payment services (cheques, electronic transfers, debit cards).
• Extend credit – overdrafts, term loans, credit cards, trade finance.
• Create money through the fractional‑reserve system.
• Offer ancillary services – foreign exchange, safe‑keeping, advisory, asset‑management.

4. The Fractional‑Reserve System & Money Creation

4.1 How a Loan Creates Money

1. A borrower applies for a loan of £10 000.
2. The bank records a new asset (the loan) of £10 000 and a matching liability (the deposit) of £10 000 in the borrower’s account.
3. The borrower spends the deposit, so the money supply (e.g., M1) rises by £10 000.

4.2 Reserve Requirements & the Money Multiplier

The required reserve ratio (RRR) is set by the central bank. Banks must hold a fraction of deposits as reserves.

\[ \text{Money multiplier } m = \frac{1}{\text{RRR}} \]

Example: RRR = 8 % (0.08) →

\[ m = \frac{1}{0.08}=12.5 \]

An initial excess reserve of £1 bn could, in theory, support up to £12.5 bn of new deposits.

5. Main Types of Bank Lending

5.1 Overdrafts

• Short‑term credit attached to a current (checking) account.
• Borrower may withdraw up to an agreed limit above the available balance.
• Interest is charged only on the amount actually drawn; usually a variable rate linked to the base rate.
• Typically unsecured – the bank relies on the account history and the borrower’s credit rating.
• Used for cash‑flow management, unexpected expenses, or seasonal working‑capital gaps.
• Illustrative calculation: An overdraft limit of £5 000 at 7 % p.a. – if the borrower draws £2 000 for 3 months, interest = £2 000 × 0.07 × (3/12) = £35.

5.2 Term Loans (including Mortgages)

• Fixed amount borrowed for a pre‑determined period (1 year to 30 years).
• Repayment in regular instalments of principal + interest (annuity or interest‑only followed by a balloon payment).
• Can be secured (e.g., mortgage on property, lien on equipment) or unsecured (personal loan, credit‑card loan).
• Interest rate may be:
  • Fixed – unchanged for the whole term, giving certainty.
  • Variable – linked to the central‑bank base rate, LIBOR or another benchmark, changing with market conditions.
• Finances long‑term investment such as house purchase, business expansion, or capital equipment.
• Example – mortgage amortisation: £200 000 loan, 25 yr, 3 % fixed. Monthly repayment ≈ £948; after 5 years the outstanding balance is about £176 000.

6. Comparison of Overdrafts and Term Loans

Feature	Overdraft	Term Loan
Typical duration	Days to a few months (occasionally up to 1 yr)	Months to several decades
Repayment structure	Interest on amount drawn; no fixed instalments; balance can be cleared at any time	Fixed instalments (principal + interest) over the agreed term
Security	Usually unsecured (based on account history & credit rating)	Often secured (mortgage, equipment, guarantee) – lower risk for the bank
Interest rate	Variable, generally higher (reflects short‑term risk & flexibility)	Fixed or variable; usually lower than overdraft rates for comparable risk
Purpose	Short‑term liquidity, emergency cash, working‑capital gaps	Long‑term investment, asset purchase, major projects
Typical users	Individuals & firms with regular cash‑flow but occasional shortfalls	Home‑buyers, businesses undertaking capital expansion, students (personal loans)

7. The Lending Process (Step‑by‑Step)

1. Application – Borrower submits a request together with required documentation (ID, proof of income, business plan, collateral).
2. Credit assessment – Bank evaluates:
   • Credit score / rating.
   • Debt‑to‑income (DTI) or debt‑service‑coverage (DSC) ratios.
   • Cash‑flow forecasts (for firms).
   • Value and legal status of any security.
3. Decision & terms – Approval (or rejection). If approved, the bank sets:
   • Loan amount.
   • Interest rate (fixed/variable) and margin over the base rate.
   • Repayment schedule.
   • Security requirements and covenants.
4. Disbursement – Funds are transferred to the borrower’s account (or directly to a seller in the case of a mortgage).
5. Repayment & monitoring – Borrower makes scheduled payments; bank records the reduction in the loan asset and the corresponding decrease in deposits. Ongoing monitoring ensures covenant compliance.

8. Determinants of Interest Rates on Loans & Overdrafts

• Base rate set by the central bank (e.g., Bank of England Official Bank Rate).
• Bank’s cost of funds – wholesale borrowing rates, inter‑bank market rates.
• Desired profit margin – varies with competition and business strategy.
• Borrower’s credit risk – higher risk → higher risk premium.
• Loan characteristics – longer maturity, larger amount and presence of security generally lower the rate.
• Macroeconomic environment – inflation expectations, economic growth, and market liquidity affect the overall level of rates.

9. Risks Associated with Bank Lending

Risk	Description	Typical mitigation
Credit risk	Borrower fails to meet repayment obligations.	Credit scoring, collateral, covenants, loan‑loss provisions.
Liquidity risk	Sudden large withdrawals force the bank to sell assets at a loss.	Maintain high‑quality liquid assets, access to central‑bank facilities.
Interest‑rate risk	Mismatch between rates earned on loans and rates paid on deposits.	Asset‑liability management, interest‑rate swaps, duration matching.
Operational risk	Errors, fraud or system failures in processing loans.	Robust IT systems, internal controls, staff training, insurance.

10. Impact of Lending on the Money Supply

When a bank extends a loan, its balance sheet expands as follows:

Balance‑sheet item	Before loan	After loan
Assets – Loans	L	L + ΔL
Liabilities – Deposits	D	D + ΔL

The increase in deposits (ΔL) adds directly to monetary aggregates such as M1. Subsequent rounds of lending by the same or other banks, subject to the reserve requirement, amplify the effect through the money multiplier.

11. Policy Tools that Influence Bank Lending

• Base‑rate adjustments – Changing the policy rate alters banks’ cost of funds and, consequently, the rates they charge borrowers.
• Reserve‑requirement ratio (RRR) – Raising RRR reduces the money multiplier, curbing the amount of credit that can be created.
• Open‑market operations (OMO) – Buying or selling government securities changes banks’ liquidity and influences their capacity to lend.
• Macro‑prudential measures – Loan‑to‑value (LTV) caps, debt‑service‑to‑income (DSTI) limits, sector‑specific credit caps aim to prevent excessive credit growth.
• Quantitative easing (QE) – Large‑scale asset purchases lower long‑term yields, encouraging banks to extend more loans.

12. Quick Revision Summary

1. Money = medium of exchange, store of value, unit of account; characterised by durability, divisibility, portability, fungibility, acceptability.
2. Monetary aggregates (M0‑M3) measure the money supply; the quantity‑theory equation MV = PT links money, price level and output.
3. Commercial banks accept deposits, provide payments and create money by lending under a fractional‑reserve system.
4. Money multiplier = 1 / RRR; an initial excess reserve can generate many times that amount in deposits.
5. Overdrafts – short‑term, usually unsecured, variable rate; term loans – longer‑term, often secured, fixed or variable rate.
6. Lending process: application → credit assessment → decision & terms → disbursement → repayment & monitoring.
7. Interest rates depend on the base rate, banks’ cost of funds, profit margin, borrower risk and loan features.
8. Key risks – credit, liquidity, interest‑rate, operational – managed through collateral, provisions, liquidity buffers and internal controls.
9. Each new loan expands deposits, increasing the money supply; the extent is limited by reserve requirements and policy actions.
10. Central‑bank tools (base rate, RRR, OMO, QE) and macro‑prudential measures shape the volume and composition of bank lending.