Commercial banks are the largest and most important credit institutions in a country and they provide important services to the population. Koch and Scott (2009) praise banks as “engines of growth” noting that the credit flow facilitated by banks is vital to the economic wellbeing of a country.
By providing credit to productive sectors, banks are able to facilitate economic growth in the country. This paper will set out to illustrate how commercial banks play a key role within the financial services sector with specific focus being given to commercial banks in the Sultanate of Oman. The paper will also address the precautions that a bank can take when offering loans. It will also underscore how the commercial banks have contributed to the robust performance of the economy in the Sultanate of Oman.
Commercial Banks: A Definition and Utilities provided
While the financial system of a country is comprised of many institutes including; commercial banks, specialized banks, and non-banking financial institutes, commercial banks dominate the financial system. Koch and Scott (2009) define a commercial bank as a firm that “accepts demand deposits and makes commercial loans and advances to its clients” (p.64).
They provide a number of core services to the community. The primary functions include accepting deposits and granting loans and advances. By accepting deposits, the bank is able to accumulate money from individuals who have surplus income. Deposing money with the bank is also convenient for the individual since its safety is assured and the person also earns interest on their initial deposit. In this role, commercial banks serve a very important role in the country since they act as custodians of public money.
The second function performed by commercial banks is giving loans and advances to members of the community. Interest is charged on these loans and advances which allows the bank to generate income. In addition to the primary functions discussed above, banks also perform various other secondary functions.
This includes: issuing of cheques to the clients, providing foreign exchange, providing safe custody of valuables in safe deposit vaults, bank transfers, and acting as a guarantor for the customer to sellers. The bank also provides trade information and statistical data that may be of vital use to the business community.
Tarawneh (2006) observes that while Oman banks focus on service organizations in general and financial services, they also offer many superior international banking services both inside and outside of the country. The banks offer other ancillary facilities which are grouped into agency services and general utility services.
Agency services which entail the bank to serve as the customer’s agent include collection and payment of bills and cheques, collection of dividends, payment of rent, interests and subscriptions, purchase and sale of shares and securities, and acting as correspondents on behalf of customers for other banks or financial institutions both nationally and internationally.
Precautions to be considered when granting loans and advances to customers
As has been noted, a major function of banks is to provide loan facilities and advances to its clients. When fulfilling this function, banks face the issue of non-performing loans (NPLs) which are loans that are not earning income and full payment is no longer anticipated or the maturity date has passed without the borrower completing payment of principal or interest (Carter & James 2002). NPLs are a critical issue for commercial banks since they can cause economic stagnation problems, reduce the profitability of commercial banks and lead to a more cautious attitude in approving new loans by banks.
Commercial banks can make use of quantitative and/or qualitative parameters to classify loans into various risk categories. The Central Bank of Oman (2010) states that all banks are supposed to grade loans meticulously, earmark downside risks and classify the loans proactively based on their risk categories. The Sultanate of Oman requires banks to use the five-tier NPL classification which classifies loans as Standard, Special Mention, Substandard, Doubtful, and Loss.
For the loans in the doubtful and loss categories, the borrowers should provide collaterals in the form of real estate or Securities which can be used to recover the loan should the borrower default on payment.
Sometimes customers who are in the Standard category (hence initially deemed as low risk) might default on a payment due to unforeseen circumstances (Genay 2000). The Banks should consider building adequate provisions to help them meet such unexpected loan risk exposures. By undertaking these measures, the bank will be able to bear the losses that might result from NPLs and therefore avoid collapsing.
The bank should engage in risk assessment to ensure that the projects which borrowers want to invest the loans in are feasible. By lending for viable businesses, the bank will significantly reduce the risk of the borrower defaulting on payment because the business venture failed. The Central Bank of Oman has come up with comprehensive guidelines on risk management that encourage commercial banks to adopt sophisticated approaches such as Value at Risk analysis, simulation, scenario analysis, and stress testing so as to monitor and expose different risks.
The report by the Central Bank of Oman (2010) notes that credit risk is the predominant risk faced by commercial banks in Oman. While traditional approaches to managing this risk have been affected by banks in the Sultanate, new guidelines have been suggested so as to incorporate modern approaches for assessing and monitoring these risks.
However, when banks have an extremely cautious attitude in approving new loans, there will be a significant reduction in credit growth. This will mean that potential borrowers are denied the chance to obtain money that they could use for capital or expand their business and therefore fuel the economic growth of the country.
The government of Oman has taken a number of measures in order to promote lending and reduce the cautious attitude by Omani banks. Tarawneh (2006) notes that the government has reduced interest rates and the Statutory Reserve Requirement and these actions have greatly increased liquidity among commercial banks.
How Commercial Banks Promote Overall of Economic Growth
Commercial banks fulfill a number of important tasks in their role as financial intermediaries. To begin with, they create money and administer the payments mechanism that is necessary to drive an economy (Saidenberg & Strahan 2004). The commercial banks then bring together various participants in the economy including; savers who make deposits, investors who generate capital, lenders who contribute to the banks funds and borrowers who take loans from the bank.
Koch and Scott (2009) illustrate that banks obtain money from lenders and savers and then pass it on to borrowers who may use the money to finance their business endeavors.
A major objective of the Central Bank of Oman is to promote high sustainable growth rates. To achieve this, it has to maintain monetary stability by making sure that the commercial banks in the country have adequate bank credit and money supply. This will result in a growth of the economy of the country and keep inflation at manageable levels. Commercial banks are an important source of financing for many businesses and the presence of these banks is therefore necessary for economic growth.
By supplying funds to borrowers, commercial banks promote investments. This is especially so since a significant portion of the credit is extended to the business community. Commercial banks fulfill the important roles of domestic savings mobilization as well as the efficient allocation of capital to the members of the community in order to foster growth. Tarawneh (2006) documents that Omani commercial banks increased their operations in the country by 11.3% from 1999 to 2004. In the same period of time, the banks experienced a growth in total deposits of 9.7%.
As a financial intermediary, commercial banks can channel funds to corporations to help them finance large projects. Like many other countries in the Gulf region, Oman’s economy is heavily dependant on its oil revenue. The government is keen to diversify the economy away from oil and the commercial bank sector is helping in this move. As a result of these diversification efforts, the Sultanate’s economy is exhibiting growth with many big projects being developed.
The Central Bank of Oman (2010) reports that the government encourages commercial banks to increase lending for new projects. This is because project spending has a positive impact on the economy since it results in the creation of employment opportunities for Omani citizens as well as the increase in profitability for corporations that engage in these projects.
Global Research (2007) reveals that the commercial banks in Oman have actively participated in the financing of many mega projects in the pipeline, mining and construction industry. With this ample lending opportunities extended to the business community, the economy of the Sultanate has experienced growth even in the harsh financial climate that the globe has faced in the recent years.
As a result of policies set up by the government, commercial banks direct a significant amount of their funds to products that make a direct contribution to the economic growth of the country. The consolidated loans granted by banks in Oman for the period 2006-10 grew by an impressive 20% with an increase in absolute amount from RO4bn to Ro4.8bn (Global Research 2007). This growth was paralleled by economic growth (Real GDP) in the same period.
Well functioning commercial banks are necessary for the commercial and industrial progress of the nation. This paper set out to document the role that commercial banks play within the financial services sector with specific attention being given to the Sultanate of Oman Banks. The paper began by highlighting the functions of the commercial banks in order to underscore the fact that commercial banks are the most important credit institutions in a country.
The focus of the government to develop the non-oil sector has contributed to the growth of the commercial banks in the country. The vibrancy of commercial banks in the Sultanate of Oman has contributed to the growth in the economy of the country.
Carter, D & James E 2002, “Do banks have an advantage in lending”, Journal of Banking and Finance, vol. 34, no. 3, pp. 563-575.
Central Bank of Oman 2010, Report of Banking Control Departments of Central Bank of Oman for the year 2009. Web.
Genay, H 2000, “Recent trends in deposit and loan growth: implications for small and large banks”, Capco Journal of Financial Transformation, vol. 3, no. 1, pp. 23-45.
Global Research 2007, Oman Banking Sector Report Oman: Proxy to Omani Economy. Global Investment House KSCC, Kuwait.
Koch, WT & Scott, SD 2009, Bank management, Cengage Learning, New York.
Saidenberg, M & Strahan, P 2004, “Are banks still important for financing large businesses”, Current Issues in Economics and Finance, vol. 5, no.12, pp. 1-5.
Tarawneh, M 2006, “A Comparison of Financial Performance in the Banking Sector: Some Evidence from Omani Commercial Banks”, International Research Journal of Finance and Economics, vol. 3, no. 2, pp. 101-112.