Why Banks Must Lend Money

For banks to stay in business, they have to lend money.  As a part of their overall operational strategy, lending is just as important as encouraging a consumer to open checking, savings, money market, CD, and other accounts.  In this article, we will address the reason why it is imperative for banks to lend money.  While this has always been an important part of business, in a competitive market and tough economy, lending is even more important now than ever before.

For banks to stay in business, they have to lend money.  As a part of their overall operational strategy, lending is just as important as encouraging a consumer to open checking, savings, money market, CD, and other accounts.  In this article, we will address the reason why it is imperative for banks to lend money.  While this has always been an important part of business, in a competitive market and tough economy, lending is even more important now than ever before.

Banks are no different from other companies in that to survive and thrive, they need ways of generating revenue.  For banks, revenue is generated in a number of ways to include offering financial advice or services to members, through various fees such as those charged for transactions, and through interest, which would be associated with loans.  Of all methods used, interest is the primary source.

In the case of lent money, banks are able to generate revenue by charging interest on capital, meaning profit comes from the differential between interest paid for customers opening deposits and other sources of funds, with the level of interest charged for the different types of loans offered.  This difference, which is called the “spread”, is between the cost of funds and interest on the loan.  When looking back over history, profits from lending has been somewhat controversial but also dependent on customer demand, as well as the strength of customers borrowing money and the current economic cycle.

In summary, banks lend money so they can make money.  However, the greatest challenge is that prior to 2007, banks were lending money to just about anyone who asked.  Unfortunately, this was a huge factor in the world financial crisis that began in 2007 with millions of homes across the country going into foreclosure and vehicles being reposed.  Because of this, the government has developed and is now enforcing strict laws that make it difficult for banks to lend money.  Even for people with good qualifications, actually getting the money requires overcoming several obstacles.

While securing a loan in today’s economy is more difficult than any other time in history, banks still need to make loans if they are going to make money.  Interestingly, although millions of people, businesses, and even government entities are still struggling from the massive credit crisis that started on Wall Street, the very banks responsible are finding new ways of making money by lending money.

For example, many banks are now involved with credit lines that are almost interest free.  In addition, these banks are now using money as a way of offering commercial loans although at much higher interest rates.  By keeping interest rates low is being referred to the “first line of defense” for central banks that want to ease the pressures of the credit crisis while making it easier for banks to lend money.  By tapping into these extremely low interest credit lines, new lending opportunities have been created.

With the low, short-term interest rates, many banks benefit especially the larger financial institutions to include JPMorgan and the Bank of America.  If you look at these two banks, you would see that currently, the raw material is short-term money, which is set at 0.25% or less.  However, the banks then invest the funds in a higher interest rate note, such as a five-year T-note with 2.50% interest.  This meals the bank is virtually locking into a system that would ultimately yield 2.25% profit, risk free.

When banks lend significant amounts of money in cases like this, the profit can be substantial.  Additionally, using this type of strategy creates an opportunity for the bank to recapitalize its system.  However, for profit to be made on loans such as this, capital could not be depleted by paying out dividends or using it to provide bank executives with frivolous bonuses.  Typically, the near-zero interest rates are an excellent way for Wall Street banks to earn significant profit.  As long as this strategy is used to push banks to lend again, it works but one challenge is that some banks are investing the interest free money into risk-free bonds issued by the government.

Keep in mind that some banks lend money as a way of building a stronger and more diverse customer base but overall, most banks lend money to make money.  The goal is that by lending the right type of money and in the right amounts to people who can afford to pay the loan notes, a cycle begins.  As the bank begins to see revenue generated, it opens the doors to other types of loans and greater loan amounts being offered.  Therefore, these banks have the ability to meet consumer demand more efficiently while the bank makes a profit.