Question

With something like a car loan, since there is collateral involved, a loan can potentially be profitable even in scenarios where the borrower ends up not being able to repay the loan out of their income. [The collateral is depreciating, of course, so the reality is more complex]

Do lenders have a responsibliity to avoid loans like these? in other words, should they shy away from loans to some extent where they think the loan is only somewhat likely to be repaid in the normal way? Or alternatively, do they have a responsibility to *not* avoid these loans; that the potential borrower's willingness to take on the loan should be respected? Does government have a role here?

Answer 1

Solution:

It is obviously true that a loan can be profitable for a lender not just by normal repayment by the borrower but also by way of using collateral in case the borrower defaults. While, lending only where normal repayment is likely should be the norm, there are exceptions where situations require lenders to go extra mile and lend even if normal repayment is not most likely. Let's take a look at the crucial factors that should govern both the situations.

Normal repayment should be the usual norm:

• It is important that the loans in an economy are generally paid put of the incomes and not disposals of assets. This ensures that lending processes don't become reckless and the process of infusing money in the economy through lending serves its purpose of sustainable growth
• It is very difficult to ascertain the future market value of collaterals. The market values of all assets in an economy keep changing significantly and it is possible that the appraised value of collateral at the time of lending doesn't hold true in future. The classic example is 2008 housing crisis wherein the lenders blindly issued debt (irrespective of borrower's income levels) assuming the housing prices wouldn't come down, which later resulted in massive defaults nationwide in the US. The primary idea should be to lend where recovery seems very likely normally and resort to recovery processes only in odd cases
• Reckless lending (based on security of collaterals) can develop in unhealthy borrowing habits which has severe long-term economic impacts.

Collateral-focused lending: Crucial in certain situations:

There are certain situations wherein it's important to lend money to the borrowers even if it's only somewhat likely to be repaid through normal ways. The classic example would be a situation where certain a sector/industry is going through turbulent times and while the normal repayment is not most likely, it's important the lenders step up based on collaterals, so that the industry could be revived and job losses could be prevented.

Similarly, it is important to lend for small businesses, farmers that need an additional degree of support, confidence and risk taking on the part of lenders. These type of loans are important for economic development of a nation, even if such loans don't fit in the most conventional financial models of lenders.

Therefore, as described above the lenders have a responsibility to adhere to responsible lending and avoid situations wherein the loans are not likely to be repaid through normal repayment process, however there are certain situations in economy (as described above) which require additional support from lenders and financial situations wherein they should go the extra mile and must lend based on collaterals even if normal repayment is not the most likely scenario.

Role of government:

The government does have a role in the above situations and is described as below:

• First and foremost, the government must ensure through effective regulations that the lending processes are responsible, encourage sustainable economic development and don't result in reckless lending.
• Also, in exceptional cases such as described above, the government must form policies, frameworks that help borrowers to get loans based on collaterals even if the risks of defaults are high. Many governments around the world have debt restructuring boards to support ailing industries, debt schemes for farmers, startups, small businesses, etc.