Is making lending decisions easy for bankers? On the surface, lending appears to be a structured, formula-driven process supported by credit policies, risk models and regulatory guidelines. Yet, in reality, lending remains one of the most complex and judgment-intensive decisions in banking.
Every loan — whether a personal loan, housing loan, SME facility, or large corporate exposure — carries uncertainty. The banker’s challenge is not to eliminate risk, but to price it, manage it, and decide whether it is worth taking.
In banking circles, a phrase often echoed in management meetings is: “High risk, high return.” While this statement may hold some truth in finance theory, it can be dangerously misleading in lending practice. Unlike equity investors, banks do not enjoy unlimited upside. Their returns are capped at interest income, while their downside can be severe — defaults, capital erosion, reputational damage, and regulatory penalties. This asymmetry makes risk management the cornerstone of prudent banking.
Retail and corporate sales teams work relentlessly to acquire customers. They gather documents, assess client needs, enter data into systems and push transactions forward under tight targets and deadlines. Then comes a familiar frustration: the credit or risk department rejects the proposal.
This often raises an uncomfortable question — do sales teams ignore risk? The answer is more nuanced. Sales teams understand customers; risk teams understand probabilities. Both see the same borrower, but through very different lenses.
From a theoretical standpoint, lending decisions are influenced by asymmetric information, a concept introduced by economists such as George Akerlof. Borrowers typically know more about their own financial health than lenders. This creates two classic problems in banking: adverse selection and moral hazard. Adverse selection occurs before lending — banks may unknowingly approve high-risk borrowers who appear sound on paper. Moral hazard arises after lending —borrowers may take excessive risks once they have access to funds. Risk departments exist largely to control these two dangers.
Another key theory shaping lending behavior is the credit rationing theory by Joseph Stiglitz and Andrew Weiss. According to this theory, banks may reject loans even when borrowers are willing to pay higher interest rates. Why? Because higher rates can attract riskier borrowers and increase default probability. This explains why loan rejection is not always about insufficient income or collateral; sometimes, it is about risk concentration and portfolio quality.
So why do banks still make risky lending decisions? One reason is competition. In highly competitive markets, banks feel pressure to grow loan books, protect market share and satisfy shareholders. When competitors relax credit standards, others often follow, fearing loss of business. History offers painful lessons. The global financial crisis of 2008 was fueled by aggressive mortgage lending, weak underwriting standards, and overreliance on collateral values rather than borrowers’ repayment capacity. Another factor is behavioral bias within institutions. Overconfidence during economic booms leads bankers to believe that “this time is different.” Rising asset prices, stable employment, and low default rates create an illusion of safety. Risk models, which rely on historical data, often underestimate risk during such periods. When economic conditions reverse, the true cost of risky lending becomes visible — usually too late.
Regulatory frameworks such as Basel III and accounting standards like IFRS 9 were introduced precisely to address these issues. Basel focuses on capital adequacy, forcing banks to hold more capital against riskier assets. IFRS 9 requires banks to recognise expected credit losses earlier, not only after default occurs. These frameworks aim to discipline lending decisions and discourage excessive risk-taking driven by short-term profits.
Yet, regulation alone cannot replace judgment. Sound lending still depends on fundamental principles: repayment capacity over collateral, cash flows over projections, and character over numbers. A house, a factory, or a business license does not repay a loan — people and cash flows do.
Ultimately, risky lending decisions are not always the result of ignorance. Sometimes they are calculated bets, sometimes strategic errors, and sometimes failures of governance. The real question for banks is not whether to take risk, but whether they understand it, price it correctly, and have the resilience to absorb losses when assumptions fail.
In banking, profit is important — but survival is essential. History repeatedly shows that banks do not collapse because they lend too little, but because they lend too much, too fast, and to the wrong risks.
Oman Observer is now on the WhatsApp channel. Click here
