Why banks are always interested in success of businesses of borrowers
Raymond Mugisha
Whenever the media breaks a story of an unfortunate incident in which a bank has taken steps to foreclose pledged property, especially belonging to prominent persons, social media spills over with reactions from the public.
A lot of this reaction is always negative, with the connotation that banks may be pleased to find themselves in such situations. To a section of the public, it appears as if banks lend out money and then look forward to when borrowers may fail to pay so as to sell off pledged properties. This is not true. Banks want customers they lend money, to succeed.
The sustainability of a bank depends directly on the success and sustainability of borrower businesses. Interest income earned on loans is paramount to the wellbeing of a bank and the more it flows into the bank smoothly, the better.
The moment a bank finds itself in a position where it must sell off a client’s property which acted as collateral, it means the client may be incapacitated in regard to further borrowing.
This means that even if the bank recovered all funds due to it from selling the pledged property, future earnings from this customer are greatly compromised. On the other hand, a client that succeeds after managing borrowed funds well, ends up in a better position to borrow even more and return more income in interest earned.
The actual value creation in the banking model is not in the act of simply picking savings from savers, keeping them securely, and availing the funds to savers when they so desire. Value creation is in borrowers taking money and multiplying it, and then giving up some of the profit they make back to the bank, to be shared between the bank and the real owners of the money who are the savers.
If the bank lends to someone who fails to pay back, the bank’s situation gets complicated. This is because the savers are not party to that arrangement and they must get their monies as and when they decide to withdraw their savings from the bank.
If the lent out funds are significant and later fall in the non-repaid category, the bank’s capacity to meet its obligations, including honoring withdrawal of funds by savers, is compromised. Banks operate with financial agreements that necessitate continuous availing of liquid cash and this is difficult when borrowers have not paid back as per their agreements with the bank.
In the meantime, while entering such agreements, the bank will have considered that clients will return what they borrowed, in the agreed time – even if with some realistic assumptions on potential default in repayments.
If the bank’s capacity to meet its obligations and financial agreements gets compromised, the central bank may require owners of the bank to recapitalise it and raise more monies to invest in the bank mandatorily. Needless to say, this cannot be sustained by investing parties if significant loan defaults keep playing out.
The process of selling off collateral by banks is tedious and costly. It costs funds, expenditure of which even if later recovered, could have been avoided. It involves administrative costs of involvement of bank executives. Perhaps though, the main cost for a bank that has to dispose of client properties is the threat to reputation, since the public is often likely to perceive this as unfair treatment of relevant customers by banks. A bank that regularly sells off client properties stands a risk of losing appeal to prospective borrowers, even if the bank has done nothing wrong.
Recently I saw someone ask why the cost of funds would be so high, if banks were interested in the wellbeing of borrowers. Loan pricing involves a couple of considerations, and one of them is the risk of loan default within a particular market. Let’s use a rather simplistic illustration to explain this.
Assume that Daniel and Joseph approach a bank to borrow Shs1m each and the bank wants to earn interest of Shs200,000 in total from the involved Shs2m. If the bank has logical reason to believe that there are extremely high chances that Daniel may fail to pay, the bank may price the loans at 20 per cent each, in a way to guarantee that the Shs200,000 will still be earned if indeed Daniel cannot pay. Joseph will therefore shoulder an “unfairly” higher burden due to Daniel.
Like in any other trade, one can find a bad transaction, where a pledged property has been sold off, and the bank is at fault over a couple of things. But these are isolated cases that do not tell the spirit and intentions of banking as a business in any market.
Raymond is a Chartered Risk Analyst and risk management consultant
