This is a form of debt financing by commercial banks where companies borrow loans and pay them back in installments. The installments may be equal or unequal depending on the terms of the loan. The loan usually attracts interest, and may be either secured or unsecured. In a secured loan, the company gives the bank an asset which may include property, machinery or a vehicle, and this acts as the collateral. Unsecured loans are those which are not backed by collaterals and may include corporate bonds, credit facilities or bank overdrafts.
Commercial bank lending favours large companies when it comes to borrowing huge sums of money, due to the economies of large scale. Benefits of commercial bank lending as a source of finance. According to Evans (2001: 34-45), one benefit is that it is convenient to acquire the loans, especially since there are are diverse loan options to choose from. There are also many commercial banks that are available which makes it relatively easier to access the loans. Another benefit is that the banks either do not have, or have very little control over how the company spends the money.
Sometimes companies borrow loans for specific purposes, and better opportunities for spending the money later arise. In this case, the companies have little restriction on how to use this money. The loans offered by banks attract relatively lower interest rates as compared to other sources of finance, such as finance companies. The companies are also free to choose the type of loan that will enable it to pay back at intervals and sums that it is comfortable with. This makes it an effective means of finance, as long as the money is used for wise investment decisions.
Most loans are also tax deductible, and this lowers the amount of tax that is payable by companies that take bank loans. Finally, like other debt financing sources, the banks do not have shares on the profits of the business, and there are no additional partners or investors who affect the decision making process of the company. Weaknesses of commercial bank lending as a source of finance One weakness of borrowing from commercial banks is that the company may be susceptible to unfair practices by banks, such as predatory lending.
According to McGrath (2000: 54-59), before banks advance loans, they have score cards which are calculated and predict the probability of the company or individual to pay back the loan. This score card is developed through observing characteristics of borrowers by the bank over time. Predatory lending occurs when the banks advance loans to companies or individuals who score poorly on the score cards. These are companies which have very low chances of paying back the loan. The banks lend them so that they might charge high interest rates, as well as take over the collateral in the event that the borrower fails to pay back the loan.
This is one reason that is attributed to the US mortgage crisis that is currently being faced in the US. Companies that fall in this trap may end up being bankrupt after being unable to pay back the money that they have borrowed. Another practice may involve usury, and in this case, the banks charge excessive rates of interest to the borrower. The loans from commercial banks are also relatively more expensive that other forms of finance, such as public offerings, due to the interest rates that are payable by the borrowers.
In case the borrower defaults on payment, the bank can retain the security that was offered as collateral. This will not only be a loss to the company, but will affect the future chances of acquiring debt financing from banks in future. There is usually a limit on the amount of money that companies can borrow, and this proves to be challenging to small and medium size companies. Such companies may not have adequate collateral to secure their loans, and this form of financing may limit such companies.