On Interest
From an original post on my old blog:
This post is going to be about the purpose of interest in banking. I’m telling you now so that you can avoid it like the plague should you so choose (and you probably will choose that, and I do not blame you.) It has been triggered by a question I was asked today by somebody who I thought should know the answer and then by a really worrying response they gave. If you already know about interest, risk and banking, do not bother to read on. This post will be (deliberately) simplistic, in order to be readable by people new to the subject.
There are two reasons why lenders earn interest. The first (and most important) is to compensate for the risk they take when loaning money. This is why interest is often higher for “riskier” loans; people in a risky category, or with a bad credit history, or in limited or troubled employment, or with no obvious way to make the repayments, things like that. The second (lesser) reason is to compensate them for the cost of managing the loan business, though this may be replaced or subsidised by an agreement fee or other charge.
If it is a banking institution then part of that interest goes to the person from whom the money originated – the person who deposited it into the bank or institution which is doing the lending. They earn interest because they have chosen to allow the bank to lend their money out and this is how they are compensated for that risk. Interest, then, is the reward for risk taken. If you are earning interest then there is implicit risk in how you have invested your money.
Sometimes, as with high street moneylenders, you hear criticism that they are Bad Guys because they charge sky high interest rates for very short term risky loans. But what they are doing is compensating for what they perceive to be much higher risks. They will know that their customers have a high chance to be unable to pay and the costs are set accordingly. If they have judged the risk incorrectly then another competitor will swoop in and offer payday loans for lower rates, stealing their customers. It is hard to see how a loan made to a consenting adult with no coercion, fraud or duress, is “Evil.” This is simply an agreement between two parties that both have consented to. Let me be clear – the use of fraud to obscure the true terms of the agreement, the sale of loans to those unable to understand what they are getting into, or the use of force or threat at any point, would make them Bad Guys. But operating within the law as the high street shops do means that people have protection from such behaviour. It may be that this protection needs beefing up every once in a while, but broadly they are providing a service that other banking institutions will have nothing to do with and that some people find valuable. The fact that you or I would advise against taking out such a loan doesn’t give us the right to close options for other consenting adults.
So a Credit Union has now been set up in Wisbech. Is a Credit Union a good thing? Is it a bad thing? It is neither. It is a neutral thing – and will only become good or bad depending on how it is run. It has the potential to be both good and bad, as most institutions do. The idea behind a Credit Union is to offering a banking service but usually in a not-for-profit environment. The customers of the Credit Union are also the owners of the Credit Union – and they elect a board to manage the affairs of the institution. Most Credit Unions offer deposit accounts with some interest and loans within the community (taken from the deposits made.) Some offer other financial services too.
The idea that the customers are the owners sounds lovely, but does fall down a little on closer examination. After all, one half of the customers (those who deposit their money with the union) are the ones taking the risk, whereas the other half (the borrowers) are benefiting from their willingness to do so. Usually, Credit Unions offer loans at better interest rates than for-profit commercial institutions. They see this as “ethical” and pat themselves on the back for their kindness and community spirit. But what they are doing is making a grand gesture with other people’s money – they are taking risk with the deposits of others and are judging the value of that risk considerably lower than market rates. That said, they are probably taking a much smaller cut for the institution, so its perfectly possible for the depositor to do well out of the deal. And there’s nothing unethical about it – since the depositor knows the nature of the Credit Union and has decided to take that chance.
It only falls down if people with no banking experience, or even business experience, are running the Credit Union. If their good intentions lead them to make loans to people who cannot repay them, because they have not properly judged the inherent risk then great harm can be done. Indeed, this year alone, six credit unions have gone bust in the UK including the very largest one of all. Usually the government then steps in and “protects” savers who have lost money, but this takes time. Of course the government doesn’t have any of it’s own money. It’s using taxpayer’s money to “protect” the savers from a bad investment that they chose to make despite knowing it was higher risk. Whether that is right or not depends on your viewpoint, I suppose.
I have every confidence that the Wisbech Credit Union will be a success and that those who are running it will do a fine job. This is certainly no criticism of them and I am sure everything will be well. But I do hope that those involved have a good understanding of the nature of interest and risk. Without it, they could get themselves in trouble.
