Loans And Moral Hazard - The Reykjavik Grapevine

Loans And Moral Hazard


Published July 5, 2010

The practice of lending money to members of one’s own group for profit is generally condemned by the Bible (see, e.g., Deut. 23:20), and this has proven to be exceedingly annoying to those trying to construct a modern financial system.
Although church authorities eventually relented on their strict interpretation of the Scriptures—perhaps because they noted that the Jewish lenders were getting all the goodies—they did retain the idea that exploiting poor people is not such a good thing for a peaceful society. Accordingly, lending was permitted, but only at reasonable rates, and many of the more imaginative collection practices were forbidden.
In many places, such as the Western world outside of Iceland, the spirit of fair competition and concerns of consumer protection have resulted in the practice of setting fixed interest rates for large loans, such as mortgages and automobile loans. If inflation happens to exceed the interest rate, it is a boon to the borrower; if the interest rate ultimately proves to be greatly above the rate of inflation, the borrower may refinance at a lower rate. Since the bank is holding most of the cards—security interests in the loan collateral, expertise in predicting default rates, valuation experts, legions of lawyers and debt collection agencies—it only seems fair.
In Iceland, however, it has been the practice of indexing residential mortgage and automobile loans to inflation. This places all risk on the borrowers, and ensures that the banks will always win.
A brilliant way of sticking it to the banks?
Surprisingly, poor consumers don’t particularly like this system, and are willing to go to great lengths to avoid guaranteeing the banks’ profits. One such device marketed in the past decade was the foreign currency loan. A foreign currency loan, as devised by our banks, indexes the interest rate, not on inflation, but on a basket of foreign currencies. While the króna and the inflation rate were both flying high, this seemed like a brilliant way of sticking it to the banks.
Unfortunately, of course, the banks didn’t get where they were by committing random acts of kindness. Although it should have been obvious to their legions of lawyers, these loans were in blatant violation of a law passed in 2001.
Now that Iceland’s Supreme Court has pointed out this inconvenient truth, no one knows quite what to do. Were the loans void ad initio? Should they be reformed retroactively? Should the collateral seized when consumers defaulted be returned? Should the ill-gotten origination fees and excess payments be disgorged?
The concept of moral hazard cuts both ways in this situation. On the one hand, the consumers had at least some idea of risk they were taking, and should have to pay the price when they lost their bet. On the other hand, the banks were in a vastly superior position to determine the legality of these loans. If the banks are not forced to accept some of the risk in the financial system, they will have no incentive to develop good intelligence or sound lending practices, or to follow the law.
These loans have caused much pain. Relieving consumers of the excess risk to which they exposed themselves is the lesser of the two evils in this situation. The banks’ purported expertise could have, and should have, saved them. They are, after all, in a position to recoup their losses from the lawyers who signed off on these loans, but the consumers have no other recourse.

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