Banks – Financial Irresponsibility

September 12, 2013 by  
Filed under Debt & Credit Free

Global financial crisis is a reality that only a few want to face rationally and objectively. It’s very easy and simple to pin the blame for the crisis entirely on the financial sector, or any other organization working within that field. However, the main reason why the finances of a lot of countries are performing abysmally cannot be put at the doorstep of one single thing. Nevertheless, a part of the responsibility can be attributed to unwise and irrational lending by banks and other financial institutions. While it is not the sole reason for the financial crash, it surely didn’t help much with the situation.

The recent financial crunch severely weakened the banking industry. Many banks have succumbed to these failures, and their number is only increasing as days pass by. As a result, bank stocks have plummeted to a record low, making investors lose a plenty of money. In response to the dire financial conditions of both the financial industry and economic recession, banks have tightened their control over lending by introducing new terms and standards. However, as result of even tighter control over the finances, the economic recovery can be delayed even further, or worse, it could lead to the collapse of the financial system. However, things have stabilized to a certain extent now.

In the initial stages, when banks started to relax their lending norms, it looked like a great idea from the outset; the banks looked forward to reap greater rewards from their risky lending, and the customers were happy to have a lot of capital in their hands. However, as it turned out in the end, it wasn’t such a simple affair where everyone made a profit and were satisfied. The banks had huge debts on their hands, whereas the customers who’d taken the loan had no means of paying them back. As a result, the banks bore great loss and put the entire financial sector in jeopardy, making it necessary for the government to intervene.

As soon as the financial crisis was in effect, banks that were lucky enough to survive tightened their loan contracts than their peers, even if they catered to a different industry or geographical region altogether. The credit shock many lenders faced was very hard to withstand at first. As a result of that, the credit availability dipped many percentages in the economy in just a few months’ time. Moreover, loan rates jumped by many basis points, while the loan terms were still pretty much relaxed in the initial stages. Having lost significant amount of money in investments, and with many loan payments to meet, the customers continued taking loans from the bank, even at higher interest rates. This perpetual cycle further fueled the economic crisis until the whole financial industry came crashing down, creating a havoc in the marketplace.

Thus, the banks had to exercise even tighter control than they did when the financial crisis began. From 2007 to 2010, the average loan spread increased by almost one percentage point. Medium and large-sized banks exercised tightened control over their loan rates, while smaller banks continued to be more lenient; however, smaller banks charged more when compared to large-sized banks. Large borrowers suffered the most, even though they were less regulated than small loans. Small borrowers continued to benefit at the expense of the bank, but most of them still didn’t have any viable investment opportunities.

To tighten the loan rates, banks used channels such as decreasing the discount on large loans, while increasing the premium customers pay on more risky loans. Also, non-commitment loans were priced substantially higher than commitment loans during the initial stages, but even they were more regulated after the financial crash set in. To minimize their risks, banks started considering multiple parameters such as including loan portfolio quality, amount of unused loan commitments, and capital ratios to judge the worthiness of the borrowers. As a result, there is clear evidence that the loans are priced based on the supply-side effect, rather than a preconceived norm.

There are many more reasons for the financial crash, but no one can deny the role banks played by lending irrationally to risky borrowers. Thanks to tighter regulations from both the government and the banks themselves, the money won’t flow as freely as it did before. Hence, you must be extra diligent and careful when borrowing money from a bank from now on.