Any kind of relief is certainly welcome right now–people need some kind of grace in the midst of this ongoing pandemic. If that’s the case, imagine if loan repayment was suddenly pardoned, every debt is erased down to zero for a year.
An annual sabbatical from loan repayment, that sounds good, right? But is this the kind of relief that’s needed? We can only imagine… and imagine we did.
Through a thought experiment, we explored this scenario happening. And the results are not promising. But before we go there, a light needs to be shone quickly as to how and why banking is important, so we could understand why a 365-day loan moratorium can set economies back several years.
Banks aren’t just a place to keep our money. No, they have a much bigger role to play in sustaining a nation’s economy. Basically, banks help keep the economic machine churning by lending out the money depositors have saved. These loans come in various products: credit cards, mortgages, personal loans, business loans, and home & car loans.
This is done intelligently by employing risk management strategies to make sure they make enough cash reserves to keep providing funds to borrowers without losing the money savers have deposited. One of the least risky ways to grow their reserves is by enticing would-be depositors to create savings accounts on their bank. The more people save, the bigger the reserve becomes.
For example, a $5000 savings account with 1.5% annual percentage yield (APY) only needs to grow to $5075 per year. Imagine a bank lends this same $5000 from that savings account to a borrower approved of a mortgage with a 5.5% interest annual percentage rate (APR). Over the course of a year, the mortgage gets paid $275 on top of the principal. Some of that goes to the savings account, yielding $75 after a year. Now multiply this scenario thousands of times with billions of dollars in savings and loans involved.
That’s why you see banks always upping the ante, providing high APY savings accounts that are twice or thrice the normal offer.
This cycle goes on and on, helping people with their financial challenges while improving people’s quality of life. And this forms the backbone of a nation’s financial system. The more efficient and less risky this system becomes, the healthier the economy becomes.
Why loan repayment suspension actually does more harm than good
Now that we have an idea how banks contribute to both the people and the economy, let us now discuss why suspending loan repayments can actually worsen our situation. Here are some possible outcomes that might occur if loan repayments are actually suspended for a year:
- Banks will stop offering any kind of credit
If loan repayment stops, this essentially cripples banks ability to loan money too. Remember that we mentioned how banks work earlier? The money lent out by banks should be paid back to them so they could continue offering credit to other clients who need them. If all payment stops for an extended period of time, like a year in this case, their ability to shell out credit stops.
- “Free” services won’t be free anymore.
While at first glance deposits seem free, they are not. Banks make them “free of fees” by requiring a minimum balance to be kept on a bank account at all times. They need to maintain this in order to maintain a healthy cash reserve and with the condition that they can lend this money out.
If banks can’t, they can’t continue operating as usual. This is where additional fees might appear suddenly. Without money coming in through loan repayments, banks won’t have enough capital to continue normal operations. They will need to have other income streams. In this case, a hypothetical monthly or yearly account maintenance fee that can be deducted automatically on the account or a withdrawal fee every time deposits are withdrawn over-the-counter or through an automated teller machine (ATM).
Actually, all these fees aren’t unprecedented. Some banks have services called safety deposit boxes where they provide a literal physical metal box where depositors can hide their valuables for safekeeping. These safety deposit boxes don’t earn interest and a bank’s only job is to make sure these boxes are kept safe. Also, unlike savings accounts, safety deposit boxes aren’t backed by insurance in case of default or loss. Items within a safety deposit box have to be insured individually.
This is why banks with safety deposit options require fees and savings accounts don’t. Since banks rely on loan repayments to keep their operations moving, people might have to start paying banks for safekeeping.
- Earned interest from savings will be gone
Banks earn money through loans via interest rates they apply whenever loans get approved. Every time a loan gets repaid with interest, that goes back to their cash reserve and because the money lent out essentially belongs to depositors, they also get a portion of the interest.
If loan repayment stops, then this “income” stops coming in as well. So there’ll be no more earned interest for deposits anymore.
- People’s quality of life will be severely affected
Due to loans not being available in this scenario (see point A), how will existing businesses grow to scale? Or how can a budding entrepreneur start a small business without the option of loaning capital from banks? How can ordinary individuals begin to take out mortgages to build their homes or buy a new car that’s essential for mobility in this pandemic?
Bank loans can help out a lot of people in their struggles. Without them, life is just a little bit more challenging. And that’s something we don’t need more of, especially at this time.
- Bank runs may occur
Another possible scenario that could happen if loan repayment is stopped for a year is a phenomenon called a “bank run”. According to Investopedia, a bank run occurs when a large number of depositors withdraw their money to the point where a bank runs out of money to cover all withdrawals.
At this point you might be asking yourself: “why will the bank run out of money when I already have them deposited?” Simple: they already lent this money out and without loan payments, they can’t get them back.
Bank runs are bad for all parties involved–banks and depositors included. This can cause banks to fold and declare for bankruptcy. If this happens, depositors who saved their money can’t get all of their hard-earned money back. Savings are essentially lost.
Without savings, people’s quality of life will be affected again. The money they saved to start a business, build a house, buy a car, pay for tuition fees, travel the world etc. is gone.
A bank run can also happen when too many loans are handed out and only a fraction are repaid successfully. This is what happened during the 2008 global recession, an event you might recall where whole economies of nations collapsed. And this is why…
- A recession will be on the horizon
Since purchasing power will become weaker due to a bank run, it also triggers other events like a recession that are unhealthy for the economy. Since everyone will be wary of spending, businesses will shrink. This leads to massive layoffs that puts a strain on the government’s social services. And since unemployment will skyrocket, tax collection from income will be negatively affected as well. Tax revenue will get choked, making the government severely limited in offering services and benefits to its citizens.
In short, this spells doom for every person involved. It’s a domino effect that leaves nothing but bad things in its wake.
You see, loan repayment suspension hijacks the whole cycle we’ve mentioned in the “Banking explained” section. This will pose serious risks to the stability of banks, which will have a negative domino effect on our economy, the government, businesses, and employment–ultimately affecting our quality of life for the worse.
Kevin Joshua Ng, is a digital marketer and contributing writer for eCompareMo.com, the largest and most trusted one-stop-shop for credit cards, loans, and insurance services in the Philippines. Kevin has nine years of combined experience in digital marketing, working with start-ups and listed companies in e-commerce, finance, and automotive from North America, Southeast Asia, and Australia.