How Falling Interest Rates Hide Increased Risk Margins
When interest rates begin to fall it can be as a result of deep concern by central banks that the economy is not expected to perform at past rates or growth. This expectation will normally manifest itself in reduced spending patterns in areas such as restaurants, personal services and other discretionary items.
The effect of falling interest rates may appear to be advantageous as current interest costs on debts are expected to reduce. This could not be further from the truth.
Imagine for a moment that the business is one of those in the hospitality industry, the tourism industry or a personal services industry.
Let’s take this example and look at a position where your current debt load carries a base interest rate of 8% plus a Risk Margin of 1.5%, totalling 9.5%.
Interest Rates in general begin to fall as a result of the expected downturn and so your base rate reduces by 0.5% to 7.5%. For many businesses this appears to be good news.
If however the bank decides to re-rate’ its clients businesses, you may find that the Risk Margin now increases from 1.5% to 2.3% very quickly with no real explanation provided aside from – “this business are considered a higher risk industry”.
This type of re-rating will often occur when an economy is going through a bad patch and customers are not spending any money. The flow on effect is that all businesses are at a higher risk than they were if the economy is doing well.
So, despite a reduction of 0.5% in the base lending rate, the actual interest rate has increased from 9.5% to 9.8%.
Even an example where the risk rating increases from say 1.5% to 1.75% should be a concern. This is because whilst banks are quick to re-rate risky industries in tough times, they rarely decrease these margins in good times without being asked.
You might find that after some time interest rates begin to increase again, higher even than where they were at the time of their original decrease.
This is another reason to fully understand the components of the bank’s risk rating system and the information being input by the bankers
