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Chapter 8: Problem 6

If you deposit \(\$ 20,000\) in a savings account at a bank, you might earn 1 percent interest per year. Someone who borrows \(\$ 20,000\) from a bank to buy a new car might have to pay an interest rate of 6 percent per year on the loan. Knowing this, why don't you just lend your money directly to the car buyer and cut out the bank?

Short Answer

Expert verified
Lending money directly to a car buyer might provide higher interest earnings, but would also pose a higher risk in case of loan default. Banks manage such risks through diversification, lending standards, and by charging risk premiums.

Step by step solution

01

Understand bank's role

Banks play a key role in financial markets by reducing risk and facilitating transactions. They earn a profit by charging higher interest rates on loans than they pay on deposits. In this scenario, the bank is paying 1% on deposits and charging 6% on loans, thereby earning a spread of 5%.
02

Analyze role as a direct lender

If you consider lending money directly to the car buyer, you must first consider the associated risks. You could potentially charge a higher interest rate and earn more, but this comes with more risk. The car buyer may default on the loan, leaving you with a loss. Additionally, if the car buyer delays their payments, such issues can arise.
03

Risk Vs Reward

In considering this scenario, you must weigh the potential reward (higher interest earnings) against the potential risk (loss of principal if the borrower defaults). Banks are able to manage this risk through diversification, lending standards, and by charging risk premiums. As an individual lender, you would not have these tools at your disposal.

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