Tuesday 3 January 2012

Be Interest Centric


An interest rate is the rate at which interest paid by a borrower for the use of money that they borrow from a lender.

For banks and finance companies, interest is the input as well as output. They borrow for interest and lend for interest. Their performance and goals are centered on interest receipts and interest payments. Gross profit of any finance company is nothing but the difference between interest earned on funds deployed and interest paid on their borrowings. As a thump rule, 30 - 40% of assets financed of any finance company is either received or paid by the name interest. It is too huge a component in profit and loss account to be ignored. Unfortunately, it does not get focused, though not fully ignored.

Do companies have a control on these? Will floating rate and / or fixed rate borrowing and / or lending solve the problem? Is risk measured? Do they hedge risk?

Foreign banks and MNCs remain focused on interest, though they do not appear to measure and mitigate risk in any scientific manner. They certainly focus on and decide appropriately ‘marginal cost of borrowing’ and ‘marginal price of lending’. They decide to borrow only if they can get at least 6-7% of marginal profitability (the difference between marginal cost of borrowing and marginal price of lending).

Marginal cost of borrowing is the incremental cost of borrowing more money to finance additional assets. Simply, it is the interest rate on the newer loan balance. Marginal cost of funds is often confused with the average cost of funds, which would be calculated by computing a weighted-average of all the combined loans’ interest rates. Similarly, marginal price of lending is the interest rates charged for new contracts / lending.

Many companies just keep raising the money like there is no tomorrow, at any interest rate and keep deploying at rates irrelevant to marginal cost of borrowing and at times even at lower rates than the average cost of funds. This creates disequilibrium and leads to unremunerative activities and consequently to operational loss. This is within the influence of top management. They may decide two important things here: 

  1. Not to lend at rates less than marginal cost of borrowing; that requires tracking and publishing cost of funds accurately every month to the top management by CFO.
  2. Rate of (profit) premium that the company must charge over marginal cost of borrowing to arrive at marginal price (interest rate) of lending. Why should they borrow if they cannot deploy funds profitably?

Most of the credit rating agencies focus on asset-liability match and fund flow match for the short term say a year; they do not seem to be testing the process of pricing in banks / finance companies. Many finance companies make higher profits from fees, charges and salvage than from core lending.

Of course, some finance companies are capable of making profits from the air; they certainly require strong top line, with no regard to any rate.

In retail finance market, most lending is done on fixed loan rate. Floating rate short term loans are not popular and impractical.

But, finance companies have a combination of floating rate and fixed rate bonds and loans in their borrowing portfolio.

If the borrowing rates are falling, finance companies stand to gain abnormally. Risk comes alive when floating rates rise; companies are forced to poke out additional interest cost from their pocket.

Some of the housing finance companies started lending at floating rates; the question remains whether they fully match floating rate borrowing with floating rate lending in tenure and quantum. If they don’t, they still run the risk.

Finance companies are advised to hedge interest rate risk by recognizing, measuring and adopting the right mitigating strategies like interest rate swaps, buying derivatives - interest rate futures, options, etc.
Or, simply borrow at fixed rate, lend at fixed rate and keep a minimum gross margin of 5-7%.