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:
- 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.
- 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%.