Much of the money banks receive from borrowers is lent to other customers. Banks charge borrowers a higher rate of interest than they pay depositors.
Lending includes mortgages, overdrafts and credit cards as well as direct personal loans. The term “retail lending” refers to loans to individuals and small businesses. Loans to large companies and governments are often described as “wholesale lending”. In some cases, several banks may contribute to a very large loan to a corporation or government. This is known as “syndicated lending”.
Banks also borrow money from each other and lend it out at a higher rate to customers. In the UK this is done on the London Interbank Market (using LIBOR – London Interbank Offered Rate). Banks’ increased dependence on short term wholesale borrowing was a major factor in the collapse of Northern Rock and contributed to the banking crash of 2007-08.
For larger loans a bank may require that the loan be secured. If the borrower fails to keep up with repayments, the bank can retrieve the funds in another way, often by claiming the borrower’s house or other possessions. Sometimes, banks will seek a guarantee from another individual or business, who commits to pay the money if the borrower defaults.
There are several ethical and spiritual issues when it comes to loans.
Firstly, when you deposit money at a bank, through opening an account there, your money is helping the bank to make loans. You may be concerned about who the money is going to. You might also want to know what interest rates the bank charges on its loans, in case people in vulnerable situations are being exploited.
Secondly, you may take out a loan for yourself, your business or your organisation. You may have ethical concerns about where the money has come from and want to find out who else the bank deals with. Of course, if you’re in a tight situation, you may have little choice but to take whatever loan you can get. If things are a bit easier, you will probably want to choose a loan with a lower interest rate, for financial as well as ethical reasons.
Some people, including many Muslims, avoid taking out loans so as not to practise usury. There has been a growth in Islamic banks that do not levy interest but charge a fee instead. Muslims are divided on this issue, with some arguing that this is usury by another name and others believing that it is an ethical alternative, with the fee paying the bank for its work.
Islamic banks also help customers to buy houses without mortgages. They will buy the house outright and rent it to the customer for an agreed period, after which the bank gives it to the customer. It remains the property of the bank until this time. This is not exclusive to Islamic banking. Similar practices have been used by many banks over time to avoid risks when lending money. It is sometimes called finance leasing.