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How Credit (lending) works

There’s an old joke that there’s only one rule that matters in banking: the 3 – 6 – 9 rule.  You pay deposits at 6, lend at 9 and be on the golf course by 3!
There’s a lot of truth in this.  Credit (or lending as bankers call it) is the key activity for banks and how they make most of their money. When you deposit money with a bank you are actually lending to them.  Believe it or not you are trusting them to return it to you and pay you a return – just like when banks lend to you – they have more paperwork though!
Of course when you deposit money you want to be sure that you will get it back.  Banks are exactly the same and this is their credit risk. They have developed sophisticated and complex systems for trying to measure this, but each lending decision comes down to this – will we get our money back?  The second most important thing is the rate of return.  Will the bank make enough money by lending to you, given the risk they are taking.  The higher the risk, the higher the rate.
Of course there are more complex factors that come into play, some quite unquantifiable.  For example banks want to know who they are lending to (hence all the identity checks) so that they don’t find themselves in something illegal (like money laundering) and hopefully the long-standing relationship you would have with them counts for something too.  They want to know what the lending is for.  This isn’t because they are experts in an area, they want to ensure that they don’t have too much risk in one place.  Of course when the margin is good enough these points can be stretched (look at the massive over exposure to the property market by some of the UK banks).
Who makes lending decisions?  Well, these used to be locally done by the manager.  He or she would make an assessment based on guidelines and the deal would be done.  More complex deals might be sent up the to the next level for sanction (approval).  The advantage here was that the local knowledge was invaluable and decision-making was swift.  The downside was that it’s an expensive way to lend (employing lots of managers) and inconsistency.
Over time credit decisions have become more specialised and centralised.  Processes have become streamlined and automated (credit scoring).  Banks can now lend more, quicker and more cheaply. They make more money too.
Without Credit life would be harder.  No mortgages, no credit cards etc.  A necessary evil.

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