Question

Discuss the statement “at some point, further increases in interest rates may decrease expected loan returns” and provide argument(s) for or against your position.

This question is for for the subject credit and lending. I would like to understand more about what I stated above. Thankyou.

Answer 1

It is true that increase in interest rates at some point may decrease exprected loan returns.

While on the outset, it may appear that higher interest rate would result in higher returns from the lender's perspective, it may not be always true. There will always be a trade-off between interest rates and the credit quality of the borrowers. Higher interest rates means that the borrower has a higher credit risk profile, therefore the chances of default is also higher.

Say for instance, Bank ABC lends $1 million to A at 3% p.a. After two years, Bank ABC decides to raise the interest rate from 3% to 5%. Assuming that the credit profile of A remains the same, A might have an option to avail the same loan from another Bank called XYZ who is willing to lend at 3%. Therefore, A can get the existing loan with ABC refinanced from XYZ. This could mean two things to Bank ABC :

• Loss of business
• Because of the compeition from other banks who are willing to lend at lower rates, ABC will have to lend to customers with higher risk profile. This could tantamount to a riskier portfolio, where there could be more number of defaults which would offset the higher interest rates charged after one point.

Financial instituitions which charge higher rates than commercial banks from their borrowers (such as non-banking financial companies, money-lenders, PE firms etc) generally incur higher costs in managing and operating their portfolios. Such companies spend substantially higher on legal and administrative costs to prevent default or delays in payment from their borrowers or investees.

Charging higher interest rates could also tantamount to providing bespoke or structured solutions to the borrowers. For instance, let's say an investing firm Sunrise capital invests $10 million in bonds of a company called Biotech which is expected to generate positive cash after two years of investment. Sunrise capital might structure the repayment schedule in such a way that they don't receive any payment for the first two years, however, in exchage of this option they might charge substantially higher rate at 12% p.a. This might mean that Sunrise capital will have to wait for a much longer period of time to break-even, also the chances of Biotech's venture failing is also higher as compared to a traditional bankable client.

Therefore, due to the above reasons, higher interest rates may decrease expected returns after some point. Lending instituitions must carefully weigh the risk versu return trade-off depending on their objective.