The Lenders Dilemma

Posted by: Rod Tyler | Posted on: October 6th, 2014 | 0 Comments

The Lender’s Dilemma

In 1969, I returned to university from a two-year stint in a volunteer organization, the Company of Young Canadians. I was 22 handshake-moneyyears old, married, with one son, and no income, and no savings. I did however have a dream-to finish an undergraduate degree, and then a second graduate degree. I believe that if I completed these two degrees, I would be able to earn a decent income at a job I could really enjoy. My problem was that I would need money to pay tuition and feed my young family. My solution was to work and go to school at the same time. But still I needed extra funds to pay for my tuition and books. It was then that I was introduced to the Lender’s Dilemma. What bank or credit union would lend me, an aspiring, but penniless 22-year-old student, enough money to get through three years of schooling, before I could even consider repaying the interest, let alone the principal on such a loan?

The answer was a Canada Student Loan. Thankfully, I and many other young Canadian students, were the beneficiaries of good federal government policy. The government of the day recognized that by guaranteeing the debt of students, the banks and credit unions would lend money to otherwise poor credit risks, such as a 22-year-old student. It also recognized that by creating more educated students, who could then ultimately become contributing members of Canadian society, they would capture the principal and the interest back over the course of time. In exchange for the federal government guarantee, the banks set the rate at a reasonable 6%, and the loans were not repayable until six months after graduation, and then at a reasonable monthly instalment payment.

So why am I telling you this story? The reason is that when it comes to lending money, every lender has a built-in dilemma – the dilemma of whether the money will be repaid, and if so, at what rate and over what period of time. This dilemma faces every lender who extends credit, loans or mortgages to individuals, or to businesses and even to countries. Managing this built in dilemma successfully is the key to a lender’s success.

Most of us, like that 22-year-old student, think that when the bank approved my student loan application, they were doing me some great favour. It sure felt that way to me. I was so excited to get my money problems solved, that studying for exams and attending classes seemed like a breeze. But if you really look at that transaction, the bank that was granting me a loan of couple of thousand dollars per year for three years, were they really doing me a favour? Not at all. They were solving their own dilemma – the Lender’s Dilemma. How could they lend money and be confident they would get the principal and the interest back over time? Because the Government of Canada was guaranteeing the loan, the bank’s loan officer was able to lend me money on a guaranteed repayment basis. The banker knew that if I turned out to be a bad or delinquent borrower, they could just give the loan back to the federal government and let them catch up with me. They now had a guaranteed repayment of principal and interest. Dilemma solved.

So whenever you look at the interest rate you receive on a term deposit or GIC, remember that you are really getting a reduced portion of the earnings that a bank or credit union is charging a borrower. The secret to running a good bank or credit union, is that to lend out money at high enough rates to reputable borrowers, or get guarantees from governments that the debt will be repaid. On the other side of the ledger, a bank or credit union, must promise to pay a high enough interest rate on deposits to be able to attract the deposits from savers, so that it can manage this interest rate differential. If it pays too high an interest rate, it will soon face its own financial demise. Astutely matching loans (considered assets in the banking environment) to deposits (considered liabilities, because depositors must be repaid), is the essence of any banking operation.

Therefore you can quickly see that whenever banks become overzealous in offering high interest rates to borrowers, they must also charge high rates on money borrowed by lenders. The higher the rate of interest charged, the more likely some borrowers will default, and therefore the result will be that the bank will lose money. If too many defaults occur, a bank becomes insolvent. The next thing that happens is the government, through its various financial agencies, has to wind up or consolidate this sort of lender. That is what recently what happened in the 2008 – 2009 financial crisis in the United States, and what also happened in the 1980s in both Canada and the US, after interest rates peaked at all-time highs.

So the next time you hear about some high interest rate paid on a guaranteed deposit of some kind, just remember the Lender’s Dilemma – if the rate they are paying you is high, then the banker must be lending money to higher risk borrowers. That practice never ends well.

And just for the record, after graduation I did, indeed, dutifully repay my student loan on time. As it turns out, the Government of Canada made a very astute investment in that 22-year-old student, since he hs been earning a living and paying taxes, a lot of taxes, for the best part of half a century. Not a bad investment at all, wouldn’t you agree?