Question

In: Economics

If banks have money to lend out they typically want to lend it to their best...

If banks have money to lend out they typically want to lend it to their best customers. But unfortunately every other bank is trying to do the same thing and this leads each of them to offer the best terms and rates. Unfortunately, once all of the best customers are taken, if banks still have more money to loan out then they will start looking for customers with less-than-stellar credit histories. Still their will be keen competition for their business as well. Banks will naturally want to charge higher rates of interest to cover for the increased probablilty of default on these types of loans. But since they really want to make these loans they might compete on something else other that price. That is some banks may simply make it easier to get credit with them by not requiring as stringent requirements as their competitors. In some instances this might even mean forgoing a formal credit check or not requiring copies of the loan applican'ts W-2 forms or check stubs. Of course eventually some of these folks who took out these "Sub Prime" loans had difficulty (not unpredictably) in paying back their loans. Some of these banks got into big trouble and more than a few have failed as a result. Is this kind of competitive activity really any different than what we see in other industries? If it is then why is it that the government believes it is their responsibilty to intervene? Make sure to explain your argument carefully.

Solutions

Expert Solution

Yes this is very different than what other firms in other industries do. All firms run behind good customers in all industries, but there a few very important differences in those industries and banking industry. These are

  • Most other industries sell stuff only after getting the amount in full. In this way they get their whole retun upfront. In banking the return is not complee until the customer has paid the loan back in full. In fact, almost all defaulting loans result in big losses.
  • The risk in most other industries is on the company itself and risky behavior usually doesnt result in a industry wide or system wide impact. In banking the risk is not only contained to the company itself, it extends to depositors and affects the whole system.

Now that we have established how the banking industry is different than other industries, it also clarifies why government's often intervene in a banking crises.

As established, a bank crisis is never limited to the bank itself. First, it affects the depositors. These are normal people losing their money because of the bank. The government cant let that happen because, if the bank is big enough, it impacts the trust of depositors on the whole banking system. If the trust of depositors is not there on the banking system, it cant work as there would be no deposits.

Secondly, in case of a big bank, the bank going down affects the whole economy as it restricts the flow of money, results in a bank run, slows down lending as all other banks become cautious. In short, it affects the whole economy negatively in a big way.

Because of these reasons, the governments consider it their responsibility to intervene in case of a bank crisis.


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