By Bob Souster

Lending is a core activity of all banks. It is the main source of income for most retail banks, whether they offer a full suite of lending products or concentrate on specific market segments. Over time, some banks choose to either broaden or narrow their target markets, depending on their own competences and the prospects and market conditions in each area of business. The lending market is far from a free market as there are barriers to entry and lending activities are quite highly regulated. While all lenders operate within the frameworks set by legislation and regulators, there are several ethical dimensions that all professional bankers need to consider. This article examines just some of them.

The Information Gap

The demand for loans is a derived demand. Just as individuals apply for credit cards for the convenience it offers when making transactions, those applying for residential mortgages do so because they want a home to live in. In both cases, they want what the product can provide; they do not actually ‘want’ a debt. To us as bankers, loans are relatively straightforward. They are contractual in nature and are formed by two parties who consent to the terms agreed. To many borrowers, however, these are more complicated than typical day-to-day transactions. Customer only apply for a credit card or mortgage a few times during their lifetime, or perhaps even just once. They are unlikely to express much interest in the detailed terms, provided the product fulfils the end need.

Over time, bankers have narrowed the information gap by improving the quality of information available to customers. Sometimes this was a consequence of hard lessons learned. For example, some of the ethical deficiencies exposed by the global financial crisis were rooted in poor lending practices which contributed to the demise of some banks and other financial institutions. These included failures among subprime lenders in the USA and the collapse of commercial lenders in some European countries. The reduction in risk appetite that followed the crisis resulted in banks adopting more rigorous ‘know your customer’ regimes as well as ensuring that products and advice supporting the customer relationship were far more transparent than in the past.

Going forward, the information asymmetry challenges will change. Technology has revolutionised the way in which banks deal with customers. It is likely that fewer applicants for credit will actually meet a human at the start of the customer journey or even during the lifetime of the loan. Technology has been used to support the lending process for over 50 years and each innovation has lessened the need for human interaction. Artificial intelligence (AI) may accelerate this trend still further, but in doing so, removes one priceless dimension of the relationship. Ask any child how they know that a parent is angry with them and it is not screaming and shouting but simply ‘the look’ of irritation that is more communicative than a thousand words. To complete many tasks, a bot can replace the person, but a machine cannot feel or convey emotion.

The Products We Offer and Terms Agreed

Interest rates are the price of money, but as we all know, there is no single interest rate at any given time. Economists teach us about the ‘term structure of interest rates’, which explains why there may be many rates of interest in the market. The determinants include the amount of credit sought, the term over which it is to be repaid, the manner of repayment (such as instalments or balloon payment), the purpose of the loan, the creditworthiness of the borrower and multiple factors relating to risk. Conventional economic wisdom regards the last of these factors as highly significant: generally, the greater the risk, the higher the price.

Consider the following example:

A finance company offers loans of up to RM100,000. The representative interest rate is 277.5%. An individual borrowing RM4,000 will pay RM636 for 12 months, representing an interest rate of 140%. The total amount repayable is RM7,632 (the numbers are approximate).

Is this legal, and is it ethical?

Provided the lender is compliant with the regulator’s demands relating to sales, conduct and provision of information, of course it is legal. This may not be the case everywhere, as in some countries there is a legislative cap on interest rates. The company, and many advocates of the free market, would also argue that it is ethical: this is clearly an example of a payday lender, whose core business is making relatively small loans to individuals who are struggling to make ends meet (many of which may be old or vulnerable, or both), so to the advocate, higher risk equates with higher return.

Conversely, there is a strong case for labelling this product as unethical. Historically, many payday lenders have targeted low-income groups, clearly understanding that those who borrow are often the most likely to default, resulting in ‘rolling over’ the loan, perhaps with a new, bigger loan at an even higher rate of interest. While it may not be unethical to lend at high interest rates, it should be regarded as unethical to use this strategy to enslave the customer to an increasing cycle of debt.

Of course, respectable banks do not do this and professional bankers might even regard it as abhorrent, but there are plenty examples of people and organisations that do so, including legal and illegal moneylenders. One of the great challenges for our industry is the argument that many go to these providers of credit because more conventional ways of obtaining credit have receded. Some have argued that banks have an ethical responsibility to promote financial inclusion and ensure fair access to credit. It is far easier to identify this as an issue, much harder to come up with practical solutions.

Another issue, and possibly a bigger one for the future, is the extent to which a market segment may subsidise another. While many banks have reduced the size of their branch networks, there is still a hardcore minority of customers who prefer to bank in person, or in some cases have no option other than to bank in person. They may, for example, handle lots of cash in small businesses and have to make frequent deposits and withdrawals. They may be unable to use the technology necessary to manage their accounts digitally. Whatever the reason, it costs the bank a lot more to provide a personal service than a digital one. Will there come a time when lines are drawn in the sand, and the privilege of visiting a branch and talking to a real person will come at a price that isn’t effectively paid for by the digital customer?

Of course, a fundamental ethical principle is fairness. We have to consider not only what we offer and the terms on which we lend, but also to whom do we lend. This is being shaped by multiple forces, including the powerful lobbies that demand diversity, equality and inclusion, as well as our responsibilities for good practices in relation to ESG (environmental, social and governance factors). Banks have legal responsibilities but have to be increasingly mindful of the nation’s commitments to the Paris Agreement, the sustainable development goals and ASEAN objectives. Despite numerous powerful international political voices rolling back on these obligations, most of our stakeholders understand the worth of ESG in shaping the future of Malaysian society and indeed the planet. This may result in banks having to make tough choices on the ‘to whom we lend’ as well as the ‘to whom we do not lend’ questions.

Robert (Bob) Souster is a Partner in Spruce Lodge Training, a consultancy firm based in Northampton, England. He lectures on economics, corporate and business law, management, corporate governance and ethics. He has worked extensively on the Chartered Banker MBA programme at Bangor University, Wales, since its inception, serving as both a Module Director and, currently, as a Moderator for ‘Ethics, Regulation and Compliance’ and ‘Financial Institutions’ Risk Management.’