Protection through interest rates

another perspective that present collateral not mainly as a means to guarantee repayment of the credit, but rather as a means to allocate priority rights to intervene and decide as regards reorganisation chances when a debtor is financially distressed.⁵⁶⁷ According to this view, creditors that are allocated seniority over other lenders by ways of security interest enjoy more bargaining power when the debtor firm is financial distressed. Because of this position, these creditors are more willing to intervene and engage in out-of-court reorganisations of distressed firms, as opposed to foreclosure,⁵⁶⁸ since they are certain of the benefits from a successful reorganisation. Hence, it is reasonable, on efficiency grounds, to grant security and thus also seniority to a single, well-informed creditor who has the incentives and the skills to monitor the debtor more effectively.⁵⁶⁹

probability⁵⁷² of the borrower to repay the loan. The assessment of information by the creditor, despite efforts to conduct a thorough assessment, can lead however only to a “good” perception about borrower’s ability to repay the loan, but not to assurance. This lack of assurance is party to be blamed on the asymmetry of information⁵⁷³ problem, and partly on the simple fact that no matter how hard one tries, one knows only partly, and therefore the evaluation of the debtor’s ability to repay will be imperfect. With respect to the asymmetry of information problem, the debtor could be blamed for misrepresenting its financial situation to give the impression of a lower risk profile, and thus benefit from lower interest rates. Or the debtor could choose to change the risk profile, usually in the upper direction, after obtaining credit, in order to compensate for high interest rates.⁵⁷⁴ But for the simple fact that one can know only partly, the debtor cannot be blamed in every case, for it is difficult to foresee what will happen after the credit has been extended. Some situations, such as, for example, consumers changing their consuming habits or tastes because of reasons totally unrelated to the performance of the debtor, cannot be foreseen, and therefore a debtor cannot be blamed for going insolvent. In any situation, it is impossible to compensate creditors for risks that could not be foreseen.⁵⁷⁵ The uncertainty and imperfection in the assessment of credit risk make the usefulness of interest rates as a protection mechanism for creditors uncertain.

2. Adverse selection and adverse incentives problems

The attractiveness of this mechanism is low especially for those types of creditors who are not in a position to collect as well as assess the information about debtor’s financial situation. With the exception of banks or of other financial intermediaries providing capital, other creditors, such as trade suppliers, will face information costs,⁵⁷⁶ which are disproportionate to the value of the transaction. Additionally, a creditor will have to incur costs also after the credit has been extended in order to update continuously the information about the debtor financial health.⁵⁷⁷

572 The focus is here on the probability rather than willingness of the borrower to pay. A creditor is not much worried about the willingness of the borrower, as thproblem could be resolved also by simply applying to a court to force the debtor to pay. However, what neither the court, not contract, nor law can do, is to increase the probability of the debtor to pay. Hence, the concern of the creditor about the probability of the debtor to pay.

573 See e.g. Dorndorf/Frank, Zeitschrift fur Wirtschaftsrecht, 1985, 65, pp. 71-75.

574 Borrowers can choose from a variety of ways to behave opportunistically with the view to expropriate lenders, such as e.g. generous dividend policy, generous bonus policy, risky investment policy, asset disposal or claim dilution by borrowing subsequently funds at higher rates, etc.

575 Posner, University of Chicago Law Review, 1976, 499, pp. 504-505.

576 Information costs include costs for collecting information from the debtor or about the debtor and the costs for assessing this information. Where the debtor lacks the expertise, he will need to employ the needed expertise, which in turn adds to the overall information costs.

577 As the debtor’s financial position can change quickly. Ziegel, University of Toronto Law Journal, 1993,

These are the costs of staying alert. If he fails to do that, then his assessment of risk will be based on information that has been rendered meaningless.⁵⁷⁸ However, because creditors cannot evaluate the credit risk for each transaction, they will tend to charge uniform interest rates on all debtors, without differentiating among them, and thus without taking into account the risk of loss associated to a particular debtor.⁵⁷⁹ This results in turn in a subsidisation of credit for bad debtors at the expense of good debtors.⁵⁸⁰ When continuing, this phenomenon could lead to an adverse selection problem, ⁵⁸¹ where the “good” creditors with a lower credit risk will be pushed out of the market for debt capital, because they will not be willing to subsidise the credit for borrowers with a higher credit risk. However, such developments could increase the overall credit risk of the creditors who are left mainly with a portfolio of low quality debtors to do business with. Additionally, the relation between higher interest rates and higher risk proves inefficient due to the risk of creating the moral hazard that the creditor wished to avoid. More specifically, debtors with lower rating will have no reputation to maintain, as they pay already high interest rates. These debtors, therefore, face the incentive to engage in high-risk-high-yield business beyond the risk level agreed before the credit was extended in order to reduce the cost of credit. As a result, higher interest rates could backfire by creating adverse incentives for debtors.⁵⁸² For creditors therefore, higher interest rates do not necessarily translate in higher return on capital. Especially in the case of banks, higher interest rates indicate higher risk, and for higher risk banks are required to hold more regulatory capital.⁵⁸³ Higher regulatory capital reduces the capital available to banks for allocating new credits, thus also lowering the overall bank’s return on capital. The efficiency of interest rates as a mechanism for credit risk management is therefore lowered.⁵⁸⁴

511, p. 530.

578 Keay, Modern Law Review, 2003, 665, p. 690.

579 Bebchuk/Fried, Yale Law Journal, 1996, 857, pp. 885-6.

580 This effect was also created by the rules of the Basel I Accord, because banks applied a standard charge of 8% of capital ratio for borrowers of the same type. For more details on the subsidisation of credit for borrowers of lower quality see chapter 5.

581 Of the type explained by Akerlof, Quarterly Journal of Economics, 1970, 488. See also Servatius, Gläubigereinfluß durch Covenants, p. 60.

582 Dorndorf/Frank, Zeitschrift fur Wirtschaftsrecht, 1985, 65, p. 73.

583 The Basel II Accord provides a more sensitive relation between risk and regulatory capital for banks, compared to Basel I. Under Basel II, credit risk is assessed individually and continuously for each creditor, either through an external evaluator (e.g. a rating agency) or internally through in-house developed systems by banks. For more details on bank’s assessment of credit risk see chapter 5.

584 Servatius, Gläubigereinfluß durch Covenants, p. 61.

3. Limitations of interest rates as a creditor protection mechanism

Strategies aimed at avoiding adverse selection and adverse incentive problems suffer from inefficiencies, which have already been discussed in this paper. For example, it is suggested that a way to avoid adverse incentives on the side of the debtor, who contracts higher-than-agreed risk after the credit has been extended, is by exerting continuous monitoring of the debtor’s activity.⁵⁸⁵ This efficiency of this strategy is limited due to the monitoring costs that a creditor will incur, which beyond the point where they equal or exceed the benefit from interest rates become unsustainable. Additionally, intensive monitoring and controlling of the debtor’s activity could subject the creditor to liability, where the debtor despite efforts to the contrary, goes insolvent. Moreover, asking for additional securities to counter for increased risk could have similar results as the charging of higher interest rates, namely adverse selection. High-risk debtors are “invited” to finance high-risk transactions through the provision of securities. This could chase away lower-risk debtors who are either not willing or not able to take over additional costs in form of a limitation in their operational flexibilities by granting additional securities over their assets.⁵⁸⁶

The interest rates that a debtor pays for the credit obtained is a natural indicator of his credit risk as perceived by the creditor. However, it is an imperfect one. It indicates only the best perception of the creditor based on his ability to collect and evaluate relevant information about the debtor’s ability to repay the credit. Information asymmetry problems as well as the general limitation on foreseeing events makes the creation of the perception by the subject to imperfections, which also affect the accuracy of the interest rates set as well as the adequacy of protection provided through interest rates. Simply higher interest rates cannot be the longer term solution to higher risk. The results could be counterproductive and suboptimal for both, creditor and debtor. From an economical point of view, protection through higher interest rates represents only a limited form of protection.⁵⁸⁷ From a legal point of view, a continuous adaptation of the interest rates to reflect the changing credit risk of the borrower⁵⁸⁸ could present legal difficulties with respect to the ability of creditors, more specifically banks, to continuously adapt the terms of their credit agreements according to the changing creditworthiness of the borrower.⁵⁸⁹

585 Dorndorf/Frank, Zeitschrift fur Wirtschaftsrecht, 1985, 65, p. 73.

586 Ibid., pp. 73-74.

587 Servatius, Gläubigereinfluß durch Covenants, p. 61.

588 The Basel II Accord presents a model on how banks are to reflect the interest rates they charge on the credit based on the credit rating of the debtor. For more details see chapter 5.

589 Kersting, Zeitschrift fur Wirtschaftsrecht, 2007, 56; Mülbert, WM - Zeitschrift für Wirtschafts- und