Sunday, April 15, 2012

Who sets interest rates?

Paul Solman in an article (link is below) about interest rates and inflation identifies three factors that affect interest rates: waiting, repayment risk, and inflation.  Then a reader in the comment section to Paul's article adds the availability of money.

O.K., so there are four factors that contribute to the variance in interest rates, but aren't we overlooking the obvious. How about the willingness of the lender to loan us the money. I know from my experience in banking that lenders evaluate hundreds of factors before making a loan: the credit history of the borrower, the collateral the loan will be secured against, the market conditions affecting the likelihood of the borrower making a profit on his loan, competition from the bank across the street, the contents of the banks loan portfolio, the business case of the borrower, the general business environment, the geographic area where the funds will be employed, etc. Granted some of these issues the bank evaluates are "repayment risk factors," but many are simply business preferences. At the end of the day the personal relationship between the borrower and lender may affect the interest rate more than "repayment risk."

In N Theory I argue it is these factors that largely determine interest rates as manifest from the two major players in the loan transaction, the borrower and the lender. It is their characteristics and their negotiation that establishes the interest rate and the economic environment in which they live. The interest rate to borrow a million dollars for a snowmobile dealership in Miami will be quite different than borrowing for the same use in Edmonton, Ontario.

The simplistic explanation of Paul Solman misses the biggest point about interest rates. He fails to consider that interest rates are set by market conditions. Of course, duration, repayment risk and inflation enter into the equation, but there are many more factors. The two most important issues are who determines the repayment risk, and at what cost will the borrower walk away from the deal. Paul ignores that interest rates are a product cost and that there are two sides involved in setting the interest rate.

First and foremost interest rates are a market negotiation (N Theory). A lender will not get her interest rate unless a borrower can make the rate fit into his business plan. Paul may grant me a few points, but I suspect his argument would be that he was referring to the interest rate set by the Federal Reserve. If his three factors are all that weighs into a interest rate, why the huge historical difference between interest rates in the past 50 years between Japan and the United States? I suspect the interest rate difference is more determined by the Japanese borrower than financial factors alone.

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