Lending Involves Managing Risks
One of the biggest roles that banks play in this is assessing and managing risk, and when you lend out money to someone there is always a risk of the loan not being paid back in a timely manner, or not at all. These defaults represent potential losses to lenders and must be made up for by the bank charging extra interest to cover these losses.
So this is why banks use risk based pricing, which means that the higher the risk of default, the higher the interest rate will be. This is used by all lenders, and this is the reason why payday loans cost so much, because the default rate with them is very high, so payday loan companies need to make up for all these losses and still make a profit.
The higher the risk that borrowers are perceived as, the higher the interest rate that will need to be charged. So the spread between what the bank pays to borrow the funds from depositors and what they charge borrowers depends on the individual situation, although we could say that the bank charges a certain interest rate spread plus the spread that is necessary to manage the risk involved.
We could take a bank’s prime rate for instance and call that the spread involved in low risk, for the purposes of explanation, even though banks do sometimes lend below prime, for variable rate mortgages for instance. The actual pure interest rate spread is actually a little lower than the best rate a bank offers borrowers, since even that rate prices in a little risk, but banks instead choose a certain rate which they deem to be their prime rate, and then price interest rates in accordance with that.
With variable rates, these interest rates are expressed as prime plus or minus the risk spread, so for instance one may get a loan or line of credit at prime plus 1%, prime plus 2%, or some other spread. The higher the spread, the higher the risk that is perceived with the loan is. These spreads are necessary entirely to manage the additional risk involved in the bank extending the credit facility.
Even fixed rate loans involve risk based pricing, as banks will often categorize borrowers by risk, and being in a certain category entitles you to a certain rate, with the least risky category getting the best rates, and the most risky that the bank is willing to lend to paying the most interest. Those who do not qualify for even the riskiest category get declined.
Risk Management In Action
Banks do have a certain risk appetite though, and rejecting all but the least risky borrowers is not the goal here, as this would minimize risk to the bank but not necessarily maximize bank profits. Any amount of risk, even the highest amounts, can be priced in, and remember, what the banks are after is to make a profit from the spread of what they pay in interest with deposits and what they receive in interest with loans, net of risk.
The reason why banks avoid getting into the riskier side of things has to do with what is called their risk appetite, and the higher the risk, the more difficult lending is to manage, with these arrangements being more volatile. Subprime lenders don’t have an issue with this so much as they exist to serve the higher risk market, and would prefer less risky arrangements but can’t really compete with banks in this regard, as they don’t have the ready access to cheap deposits that banks do.
So it costs more for subprime lenders to raise capital to lend, but given that they are in a niche market, serving borrowers that can’t qualify for bank loans typically, given they aren’t really competing with banks, the higher rates they must charge due to higher costs of their borrowing isn’t really an issue.
Banks on the other hand need to pay more attention to protecting their depositors and therefore have a lower risk appetite based upon that. Also, given that banks do not have unlimited resources to lend, and have the pick of the crop so to speak as far as who they are going to lend the money they do have to lend to, they have the luxury of focusing on lower risk lending.
If a bank for instance decided that they would open up their doors wide enough to price in any amount of risk, they may not even have the means to lend that much out, as banks do need to have the money to lend on hand, the deposits in other words, and this does serve to limit them.
The Factors Involved In Managing Lending Risk
As far as the criteria involved in assessing the risk of a borrower, there are some that are fixed and some that are variable. Having a sufficient income to service the loan is mostly a fixed condition, and if one does not have the proper amount of income, one won’t qualify for a loan or line of credit anywhere, even with subprime lenders.
No one wants to take on arrangements that are destined to fail, although subprime lenders have less stringent income requirements, and even banks have a certain debt ratio tolerance that they are willing to price in, especially if the loan is to consolidate debt already held by the bank.
People often think of credit scores as driving this, and it certainly does to a large degree, and credit scores do assess one’s predicted credit worthiness based upon their credit history. So banks will set a minimum credit score necessary to borrow at all, and within their accepted guidelines, will price risk according to these scores.
There is also the tendency for banks to have a higher risk tolerance for smaller amounts, for instance some banks will extend small amounts of overdraft or a low limit credit card to clients who would not qualify for many of their credit products.
Having the debt secured also affects the risk to the bank, and it isn’t just that the bank can take possession of the pledged assets if necessary, as secured credit also has lower default rates due to the borrowers having a bigger stake in the timely repayment of the loan, as borrowers do not typically want to forfeit the pledged assets.
The main factors that go into risk assessment with bank credit comes down to the ability of one to repay the loan, whether something is put up for the loan, including a down payment, the purpose of the loan, and the reliability of the borrower based upon their history and present circumstances.
Borrowing money is an integral part of today’s society and is necessary for most people to get what they want and need in a timely way, without having to save up for years to get it. In a sense, other people have saved up for them, and pledge this savings to them in a roundabout way, getting a cut of the profit of the loan in interest paid on their savings.
This all requires a lot of expertise and resources to manage effectively and banks serve this intermediary role, to keep the money flowing between the two groups while properly managing the risks involved.