Question

what are the consequences of violating the principles of lending

Answer 1

There are few basic principles of lending which should be followed with utmost regulation.

1. Liquidity - Banks use customer's deposits to lend for short periods. These short term loans are given on assets which can be easily liquidated should there be any need as such to the depositor for his money. Thus liquidity is of paramount importance here.

2. Safety - Safety of the amount that is lent is very important. This parameter depends on the ability of the borrower to repay the interest and hence the loan at regular intervals. In such a scenario the principle lent is safe and the bank is receiving its interest and principle in parts. However what is important is the regularity with which the borrower is paying the EMIs on time.

3.Diversity - The bank should basically diversify its lending portfolio into debentures, loans, bonds etc. This would help the bank to hedge the risk should any one default occur. This is important because there can be a concentration risk if too much focus is on one single investment avenue.

4. Stability - This is an issue which is of critical importance. There should be stability of the borrower and all lending should be done keeping in mind the stability and consistency of the borrower. No lending should be done to a borrower whose past track record is full of defaults or errors of any kind.

5. Profitability - The bank should ensure that the amount lent should be on a higher interest rate than the deposit rate. This would mean additional income for the bank in terms of the interest rate spread.

The consequences of violating the principles of lending can mean that there can be a run on the bank if there is a liquidity issue as the news can spread like wildfire. If the bank does not take safety into consideration and also takes concentration effect, there can be a bankruptcy issue with the bank.


Stable and profitability would mean that the bank can do business for a long term. Not focusing on it would mean that the bank would be wiped out in a short period of time. The repercussion of this is the loss of trust in people in the banking system and collapse of the complete financial system. This is because it acts like a chain reaction. A default at one place leads to panic and fear and hence even good banks who follow the above 5 principles also get negatively affected.