1.4.2 Risk and liability

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    Banks will charge higher rates of interest to people who are more at risk of not repaying in order to get as much back of their money before they default on payments. Banks assess creditworthiness before giving out loans, those who have unpaid loans in their past will get higher interest rates or not receive a loan at all.

    Risk –  the possibility that events will not turn out as expected (uncertainty) e.g. lower than        expected sales. It also includes the probability of damage, loss or injury happening.

    Some risks can be calculated by referring to past experience and data.

    RISKS TAKEN BY BANKS

    • Investments not giving a good return.
    • Borrowers not paying back their money
    • Don’t have sufficient funds to pay all their savers if all wanted their money back

    HOW DO BANKS DEAL WITH RISKS?

    1. Banks have a range of borrowers
      • Some borrowers will not repay but other borrowers will.
      • This means safer borrowers will compensate for the riskier ones.
    1. Banks ask for collateral
    • In order to reduce the risk of non-payment as people will have more incentive to pay.
    • Also, they gain value from the item they can repossess so less risk for them.
    1. Take care who to lend to
    • They use credit scores to see who is more likely to pay back their loans.
    • They give the safer buyers lower interest rates, so they will continue to borrow and give riskier businesses higher interest rates to reduce risk of non-payment.
    1. Specialise in particular types of lending
    • They will give out similar loans i.e. investment banks give out big loans.
    • It makes assessing a loan easier as they know more about who/what type of person they are lending to as they know the markets better.
    1. Monitor their (own) accounts
    • By using their credit score and their previous credit history banks can tell who will back and who won’t.
    • They can charge different interest rates to each business depending on their credit history.
    • They will need to check that withdrawals are not more than deposits.
    • Then if they are they will borrow from other banks (inter-bank lending is used to cover short term debts that result from day to day trading).
    1. Keep careful track of risks
    • Some risks can be quantified which allows them to judge borrowers and investments against each other.
    • They can get a safer return on investment or more money on it.

    Credit cards have the highest rate of risk as they are used by people who cannot get other types of loans. There is a high chance that they will not be repaid. A higher rate of interest is charged to compensate.

    There is a trade-off between risk and safety. Risky loans can be more profitable as more interest can be charged whilst safer loans ensure a constant supply of funds.

    Unlimited liability is when the business and owners are one in court and if the debts are not covered by the business’s assets then the owner’s personal property can be used to cover the debts of the business.

    Limited liability is when the business and owners are one in court and owners will only lose what is invested into the business. It is preferred in riskier businesses such as insurance where potential risk is high.

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