Question

Explain 3 of the basic principles of lending. What are the consequences of violating these principles of lending?

Answer 1

3 basic principles of Lending :

1. Liquidity : Banks should be able to meet the demand of customers whenever they require it. They cannot deny the customers their money. For this banks invest in marketable securities, provide short term loans, invest in treasuries,etc which can be easily liquidated and have short tenure to meet the sudden increase in demand by customers.

2. Diversity : Banks should not loan to only one type of customers or invest in one type of securities.Their loans should be diversified .They should rather invest in multiple type of securities in order to diversify their risks.This minimizes the risk of return.

3. Profitability : For sustainability and prevention of erosion of capital banks should try to be profitable

Consequences of violating these principles

1. Banks won't be able to pay its customers on demand.
2. Bank's capital will erode and they will have a pile up of toxic assets.
3. Bank's operations will be in danger and may need a bailout package by the feds.

Please Discuss in case of Doubt

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