Financial Fuss (4) - Normal Banking Practice

The normal process by which a bank decides whether or not to make a loan is relatively straightforward. Two questions are asked.

1. Will the borrower be able to repay the loan and any interest when it comes due?
2. What assets is the borrower offering as collateral for the loan?

These questions have been forgotten over the past decade. Banks have lent to people who had no possibility of paying back the loan. They have lent to investment banks and hedge funds offering security of unknown value. Those days are over, and not too soon.

Banks will go back to asking the old questions. Businesses and households that demonstrate an ability to make the repayments will be able to get finance. Interest rates will be higher, but those who get over the higher hurdle will get funding. Borrowers with good security will be able to get finance. A ninety percent mortgage on a house will not be considered good security. In many areas, a twenty percent deposit will not be enough. A collateralised debt obligation that has had the risk sliced and diced a thousand ways according to a mathematical model will not be adequate security.

Applying these rules will dramatically change the finance sector.