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A look at the Great Recession and loans

Katie Schenk - June 10, 2016

Bank of England in the City of London

If you take a serious look at the way banks operated before the world plunged into what’s now known as the Great Recession, it’s easy to see that a financial crisis was almost unavoidable. But hindsight is, as they say, 20/20.

Still, banks had a relatively silly business model: borrow the money deposited in bank accounts and lend almost all of it out as quickly as possible. Without holding on to more of the capital, even a little tremor would have brought banks to their knees.

That’s not to say the model of borrowing money to loan money doesn’t work; Prodigy is proof of that. But, the quakes that shook the financial industries to their knees didn’t break the system; it exposed the fact that it was already broken.

Behind the Great Recession

It’s easy to find in-depth reports of the Great Recession or the Banking Crisis; it all depends on how much you want to read. Nearly all of the early research focuses on subprime loans in the mortgage markets. And certainly, the earliest warning bells of the global plummet began when subprime loan holders defaulted, reverberating through banks across the globe. But, as Wharton economists Fernando Ferreira and Joseph Gyourko point out, we can’t pin the tail on subprime loans as plenty of prime loans contributed to the collapse of banks and the banking system.

We’ll have decades to rehash the Great Recession, using small banks as case studies and debating the alternative responses in classrooms and over beers. But, we can’t erase what happened, even if it is difficult to agree on the specific triggers.

What is obvious, however, is that banking and lending were (and remain) broken.

Whether Fannie Mae and Freddie Mac were spurred to provide as many loans as possible through government pressure or individual greed is almost irrelevant. We could debate whether banks that became enlarged through the acquisition of smaller banks as a result of governments almost begging them to do so should be punished for their size by the same governments. But the fact remains that something always needed to change.

The effect on consumers and loan applicants

Governments were backed into a corner of bailing out banks to avoid more terrible ramifications. In the aftermath, governments adopted stricter legislation. But, before that happened, banks had to take stock. Without interbank loans, there was nothing to lend – effectively cutting consumers off from property and cars, education, and the small business development loans that could have driven faster recovery.

It’s not as if loans dried up completely; banks just didn’t have as much to dole out and had to be choosy about who they lent to; they needed income that was more certain and less speculative. Sadly, individuals and families that had done everything right were stuck. It fueled the outcry against banks and bankers that were seemingly rewarded for making the decisions that led to the loss of jobs and houses. Governments had to react and react again as the call for tighter restrictions became louder.

Still, day-to-day banking hasn’t changed that much. You’ll still earn less than one percent interest on savings deposits to the same bank that charges you 18 percent on your credit card. Even loans issued by banks aren’t drastically different. Though there are new policies put in place to avoid another loan-fueled Great Recession.

New loan models as a result of the Great Recession

There has, however, been a dramatic shift in the loan market outside of banks. The inability of banks to loan to consumers (when they didn’t have the funds or through increased regulations) doesn’t halt the need for houses, education, or entrepreneurial ventures. Even as the sharing economy develops, there are individual needs that must be met. New models to provide these loans had to be developed. And they were. Prodigy is an example of new methods, but it’s not the only one. Companies like Lending Club, provide small business and medical loans through peer investments – and developed almost directly as a result of banks’ inability to lend.

It’s not to say that new, disruptive companies providing loans couldn’t (or wouldn’t) have developed without the Great Recession. It’s not as if the collapse of seemingly infallible banks created an opening that didn’t exist previously. But, if you’re looking for the silver lining, it’s likely to be the market’s willingness to consider new ways of funding – especially when they’re built on more sustainable business plans than banks once had.

Want to know which programmes Prodigy can assist with funding? Take a look at this list or read more about Prodigy's investing community here.

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