Lending risk: A different explanation

In a previous article published on December 19, 2013 in the Financial Express, we tried to argue why higher risk and higher premium rule doesn't work well for banks and why this rule causes in most of the cases problems for banks.  The explanation in that article was developed analysing the characteristics of market mechanism for banks and how such mechanism differs for banks. Still another explanation is possible from a very basic sense. We can also give a very simple and catching explanation without getting into complex market mechanism analysis. This paper aims to provide this explanation.
LENDING RISK: A BUDGET CURVE BASED ANALYSIS: In the previous article we visualised the economic behaviour and act of a simple hypothetical orange seller in market. Here we will keep continuing expanding on such simple and representative seller's example.  As explained before, the orange seller has two options: he can either sell in cash or credit. If he sells in cash only, then he sells none in credit, and if he sells in credit only, he sells none in cash. In such a case he has to calculate two returns: one is buyer's return if he sells in cash only and another is borrower's return if he sells only in credit.  Instead of selling the whole lot of oranges in cash or credit, he will prefer a mix solution in which he will sell some in cash and some in credit. Therefore, we get his total revenue from selling as:
From the above analysis, it is now clear that the return qt+1is in fact the return promised by borrowers to hand over at time t+1. This promise has two characteristics: First, this promise is an expected promise from the perspective of the seller and that is why we have inserted E (expected) sign before qt+1 in the above constraint. Second, the promised return may or may not lie on the current or real budget constraint of borrowers. That means he may promise such return keeping in his mind a budget constraint that is far ahead of time t or current estimate. Even then this should not create a problem if he has some rational expectation about future and forms an iconic view of future in the current estimate.  However, this rarely happens. But why? The explanation comes from a very commonsense. Paying cash out of the buyer's wallet now and paying out of the future wallet at some future date are not at all same and equivalent. But banks often confuse them. They give loans following higher risk and higher premium as if they were selling in cash only. This point is illustrated in the following graphical view.
In the above figure, borrower's return (q) and buyer's return (r) are measured correspondingly on the horizontal and vertical axes and the return is measured in gross term not in percentage term here. The three straight lines AA, SS, and RR indicate three constraints. Since the seller will some oranges in cash and some in credit, he has to calculate both the buyer's return and the borrower's return while selling oranges. Let's say he sells L0 in cash at some return r0 and sells L1 in credit. Now the question is to whom he will sell in credit and how much should be the stipulated or promised return by borrowers? If he follows the strict rationing rule and sells only to those who are to keep the promise, then the rational return must be q0. The reason is that q0 is such a return that is almost free of default risk and it is this return which the orange seller can expect to get from the borrower with almost certainty.  Therefore, his he will remain on the AA constraint. On the other hand, if he follows the higher risk and higher return, he will sell to such a borrower who bid a return that will be far above the rationally justified q0. In fact he will bid aE[qt+1] return which is  greater than E[qt+1]. Since a>1, this return is based on higher risk and higher premium rule. By this we should expect to remain on the RR constraint with r0 return from the buyer and aE[qt+1]=q2 from the borrower. But this doesn't happen. When borrower's promised return moves from q0 to q2, seller's expectation about r0 also increases. In other words, it rises above r0. Now appears the dilemma. When r0 moves up and q moves from q0 to q2, we find a point that is far outside the RR constraint. The shaded triangular region above the RR constraint is exactly symmetrical and of the same size of the triangular region between AA and RR whose height and based are formed by dashed lines. What does this shaded area imply? It says that higher risk and higher premium rule creates an inherent risk of default and banks are more likely to be trapped in such problem when they follow the higher risk and higher premium rule or higher risk and higher interest rate policy. That means q2 is a default risk generating return and banks should avoid charging such rate giving loans to those who will bid this keeping an ill motive in mind.
LESSONS: From the above analysis we get some valuable lessons. First, banks and other financial institutions should try to avoid the conventional view and guidelines such as offsetting risk by charging higher rate. This policy is totally counterproductive and lacks any rational and practical justification. Second, higher rate accrued from higher risk is in fact the default risk generating rate and this rate causes loan defaults problem for banks. Third, most of the default risks can be safeguarded if banks become a little more judicious in lending by following some discretionary rules instead of responding to ordinary market impulse since conventional market mechanism doesn't work well for banks and financial institutions. Finally, this point is stressed again and again that lending is not like selling oranges or potatoes in market where you react to market impulse seeing whether market overshoots or undershoots and adjust price accordingly.
In this price adjustment method nobody worries about inequality and inequity; all that matters is whether market gets cleared or demand and supply of potatoes and oranges are equalised at the adjusted price. If somebody gets the large share of the whole supply of oranges and others get almost none, that doesn't matter. But lending is not like that. It is more equity- and equality-oriented. A lender can't blindly charge a rate to clear the market. In fact, it is not the task or duty of a lender to do as such. But the real frustration is that the conventional market-oriented teaching from the classical economics has so totally engulfed the whole finance discipline that even today hardly few people realise that lending market mechanism is characteristically wholly different from the ordinary market mechanism.
Md Jamal Hossain writes from the                                   University of Denver, USA.                              [email protected]