Capping Banks' Rates

I've recently been in a discussion win which some academic proposed an interest rate cap for bank loans. When I asked whether he meant during the crisis or in general, his answer was "of course in general". His argument was that given the Modern Portfolio Theory which states that specific risk can be diversified away, when banks have a large amount of people as loan-takers then their individual risk will be diversified away and all you will be left with will be systematic risk which you can do nothing about. Thus, if the risk you have is just the latter, why should the banks charge different interest rates to lenders?

Although at first the idea might sound appealing to some, (it also abides with the "banks are bad people are good" motto), the problem with these kind of statements is that it shows a basic misunderstanding about how both the banking system and the risk-reward relationship actually work. To begin with, even in academia, higher risk is associated with higher reward. The basic reason is that you require a higher expected return to invest in something which will have a higher probability of costing you money. Simply put, if the risk of losing money is 10% one will surely ask for more potential money than if the risk is 5%. Thus, if the bank chooses to lend money to someone who has a 10% probability of defaulting then it makes sense to charge a higher rate than the one to be charged to someone whose probability of defaulting is just 5%.

"Sure" the academic would go on "but that risk can be diversified away". Well it depends what you really mean by that. Suppose that you have a stock market with stocks, between which you have to distribute your funds, having the following risk-return relationship:

Now suppose that someone told you that regardless of the risk, all stocks would have returns of exactly 6%. Where would you put your money into? Any reasonable investor would not be foolish enough to put his money in any stock which has a return of more than 6% in the above scenario because he knows that he will not be compensated for the risk he will assume. Thus, stocks 1,4,7,8,9 and 10 would have no-one to purchase them since their return would not be sufficient for the risk the investor assumes. In addition, stocks 2,5,6,11 and 12 would receive too much attention from investors since the risk they are posing is very little compared to what the capped return has become.

Let's put this is into banking perspective: instead of stocks, we have loans. Loans with higher expected return are those with higher interest rates, as for example business lending. If we cap the return banks can have at e.g. 6% then there will be loans which will not be issued, although in normal times the bank would most likely assume that risk and provide the funds (at a higher rate of course). What would this mean: essentially, those who have safe assets they can put as collateral, such as real estate or cash, would get funding while those who do not (for example 90% of the population) will not. This policy is not that terrible to the banks as they can adjust for these shortcomings; it is much more hazardous to the ordinary person who does not have collateral and cannot borrow at the low rates the bank will offer.

Why can't we force the bank to lend to the little guy you might inquire. Simply because the little guy bears more risk than the "big" guy. The bank has the discretion to reject any loan application it does not fit its risk-return profile. Forcing the bank to take up any loan while at the same time capping the rate is not a good idea; unless of course we really want another sub-prime lending crisis. 

In addition, high risk loans require higher capital requirements: business and consumer loans without any guarantees require much more than the 60% it is required for guaranteed ones. But the banks still give them. Not too many of course but they do. The thing is that if you take out all of the high risk loans you will be left out with no new Facebook, Google or Twitter. To get big you have to start small. And small without any lending is just tiny.

The reader would notice that my question was on the timing of the policy: if this is just a policy to be implemented as a short-term one I would have no problem against it. Why? Simply because just after a crisis banks are less willing to lend, and if they do then they lend to those who has a very low risk profile (i.e. the "big" guy). You don't have to take my word for what I described in the previous sentence; Hyman Minsky and Joseph Stiglitz said it much better, more than 30 years ago. Thus, as banks are less willing to give out funds, it would be much better to cap the rates during a crisis than after or before it for the simple reason that it would be much better for the existing loan-takers. It would take the burden off their shoulders, create an additional boost in consumption (or increase savings), thus moving us out of the recession. 

The short-term nature of this cannot be over-stated. If such policies are to be followed in the long-run then we would be in a situation where those who have will get more and those who haven't would get nothing. This is not only unfair it is also economically inefficient as, growth would also be threatened under such a scenario as no new high-risk projects would be assumed. Summing up: capping bank rates is good for the short-run, but only during a severe banking crisis; otherwise it does more destruction than benefit.