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On average stock markets make about 7% per year adjusted for inflation. So given the choice of lending a stranger money who will give me <7% APR or putting it in the stock market for a few years I would put it in the stock market since it has a longer track record of making money (the borrower has a higher chance on defaulting than the stock market has of never rising) and on average gives higher returns.

So my question is this: Wouldn’t it make more sense for the money bankers lend at less than 7% APR to put in the stock market? How would they make more money by lending it to me?

Here are the 2 reasons I can think of off of the top of my head:

  • Credit cards also make money from Merchants each time I buy
  • If I fail to make my payments for a long time I will owe a lot more money.

The first sounds reasonable but then again banks give loans at lower levels so that can’t be the only reason. The second option still doesn't seem to make a big enough difference to justify this since the banks will make more money from compounding in the stock market.

Am I missing something obvious here? It seems like it’s always in the best interest of banks to put their money in the stock market than to give to individuals?

closed as too broad by NL - Apologize to Monica, Dheer, Pete B., Joe, JTP - Apologise to Monica Feb 14 '18 at 12:51

Please edit the question to limit it to a specific problem with enough detail to identify an adequate answer. Avoid asking multiple distinct questions at once. See the How to Ask page for help clarifying this question. If this question can be reworded to fit the rules in the help center, please edit the question.

  • Can you give an example? – Acccumulation Feb 7 '18 at 16:35
  • @Acccumulation My credit card is 6.45% APR. So that’s an example of banks lending at less than 7% – KNejad Feb 7 '18 at 16:40
  • Is it a teaser rate? – Acccumulation Feb 7 '18 at 16:42
  • This question is directly related to "commercial finance", not "personal finance". – WakeDemons3 Feb 7 '18 at 16:42
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    @Acccumulation No. This is my first credit card when I have absolutely no history of borrowing with a permanent rate of 6.45%. Which is the reason I’m asking this question. It seems like a bad idea for the bank to do this. – KNejad Feb 7 '18 at 16:45
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I think your question can be simplified to:

Why do banks offer certain products that don't maximize their return?

The answer is a combination of asset allocation, risk, and long term goals. No bank would want to put 100% of their money into the stock market. They need to diversify by trying to beat the market with some high risk investments, and also reduce their risk with some conservative investments. There are many products that banks offer that don't directly make them money. Examples are free checking accounts without minimum balances, or balance transfer offers at 0% interest with no fees, or low interest rate loans and/or lines of credits. Collectively, a bank's entire portfolio is designed to make money, but obviously not every product does on its own. Many products banks offer are designed to attract new customers with the hopes that some of those customers will turn into wealth investment accounts in the future. Other products are designed just to prevent existing customers from accepting attractive offers from other banks that may try to steal them away.

In your particular case, even a low interest rate CC may be a better risk than the stock market, depending on your profile. You may find it odd that they consider you such a good risk, but you don't know the bank's motivations. They may have knocked 10% off the normal rate for the next 10K customers instead of spending it on marketing.

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Am I missing something obvious here?

Yes - credit lines at less than 7% are only extended to those individuals with a good credit history, so their risk of default is very low, and as such their risk is much less than that of the stock market. They are often promotional as well, meaning that they don't last forever (yes, there are exceptions), or the interest accrues at a much higher rate that is due of you don't fully pay it off on time.

And you are correct, the banks also profit from the fees charged to merchants and other fees imposed to consumers. The bank's model is that on average they will earn a profitable interest rate (e.g. 2-3%) through merchant fees, accrued interest, late fees, etc.

the borrower has a higher chance on defaulting than the stock market has of never rising

You're comparing apples and oranges - you should probably be comparing the probability of default versus the probability of the stock market earning less than the risk-free rate, which is most definitely higher than the probability of a credit card holder defaulting.

  • " which is most definitely higher than the probability of a credit card issuer defaulting." I take it you mean the card holder, and you mean low-risk cardholder? – Acccumulation Feb 7 '18 at 16:44
  • @Acccumulation Yes, thanks. I don't have stats, but I would expect that any card holder defaulting is a lower probability that the market earning less than risk-free rate, which happens quite frequently. – D Stanley Feb 7 '18 at 16:48
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    I think your first point is key. Lower returns implies lower risk for the investor. The bank considers a 6.5% return on certain individuals a safer bet than a 7% return in the stock market. – Nuclear Wang Feb 7 '18 at 16:54
  • Make sure to readthe fine print; it could be that means 7% over base rate. – Aganju Feb 8 '18 at 2:33
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To answer your last point, yes it is in the best interest of the banks to invest rather than engage in solely fractional reserve lending or giving credit cards to consumers, because as you said, the counterparty and default risks are much higher with an individual.

On a wider scale, the Dodd-Frank Act after the Great Financial Crisis of 2007 greatly limited banks' ability to invest in markets. Before Dodd-Frank, there was no definable line between investment banks and consumer banks. This gave large consumer-based institutions the ability to set up what are called proprietary trading desks. Essentially banks could invest the money they made into whatever markets they wanted with minimal oversight.

Obviously this did not pan out well in 2007-2008 and Dodd-Frank reinstated the line between investment and consumer banks. Prop desks were essentially weeded out of financial institutions. This is NOT to say that financial institutions cannot invest in markets at all anymore. They can and do. But they are severely restricted in using their own capital to do so.

Back to your main question, this is why consumer-facing institutions mainly deal with consumer-based lending activities (think of Bank of America) while investment banks (Merrill Lynch) primarily engage in capital markets.

  • I disagree with your first paragraph. High credit-score borrowers should be a much lower risk than the equity market. Mid-to-low credit score borrowers would not be offered such low rates. – D Stanley Feb 7 '18 at 16:43
  • @D Stanley I see your point, but the majority of credit card holders will have nowhere close to a 7% APR. OP has great credit and/or a lengthy credit history. – HK47 Feb 7 '18 at 16:46
  • The average credit card rate is over 16%. – D Stanley Feb 7 '18 at 16:52
  • @HK47 I am 20 years old, have never had a loan, have never used credit before, and a university student. Yet for some reason they offered me 6.45% That’s hardly enough history for me to be considered "good credit". Perhaps I should ask a second question as to why I got such a great deal then... – KNejad Feb 7 '18 at 16:52
  • Here is the question if interested: money.stackexchange.com/questions/90542/… – KNejad Feb 7 '18 at 17:13

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