byRafayiliKayigwa on Monday, 10 September 2012 at 22:04 ·
Have you noticed that when you go to ask for a loan, the officer behind the desk says to you that the interest rate shall be floating. Or if they decide to fix it, it is ridiculously high you wonder why even with your impeccable credit history and cash flows you are still considered “risky”? Well, they do not. You are simply paying for those other fellas who took on loans but found it difficult along the way to settle the amount.
You see, the banker shall need to meet his goals of making returns for his investors and as such in his wisdom has decided to spread his risk of defaulting clients to those who are honest. Much as the defaulted loans are few because from inception the loan officer shall take all measures to assess the risk capacity of a new loan applicant and weed out all those with high risks, there still remains a small percentage which defaults. So not to be the sucker holding the biggest piece of stinking turd when the music stops, the banker spreads the risk of default over his entire portfolio. This of course ensures that he minimises his risks to the bare minimum and it goes without saying the honest folk pay for defaulters.
A complicated formula is thus used by the banker to determine the most opportune rate to offer to his borrowers. He has to consider all kind of factors such as the probability of default, the probability of recovering money of loans on which default has occurred, the time at which these may occur among others. With all this, the lender is trying to compute the credit risk.
There are five factors which will form the base that the lender shall use to determine cost of the debt. The factors include; the value of assets staked by the borrower as collateral, the time it will take the borrower to return the borrowed funds to the lender, the volatility of the assets and the risk free rate. These factors were put together in a super mathematical model the formulators for which earned a Nobel Prize.
The model, the Black Scholes Option Pricing Model has been used to compute a lot of things from cost of debt to value of shares or a firm as a whole. It has also had its own criticisms most recently being the over reliance by bankers in using this model to determine the cost of debt which led to fall in value of this debt triggering the deepest recession since the second World War.
Nonetheless, the model gives us a great insight into the mind-set of the lender and the factors that he determines are integral in his determination of the rate of debt he will charge. All factors mentioned above are easy to determine save for the risk-free rate and the volatility of assets. However, most lenders use the interbank offer rates such as the CBR for Uganda and LIBOR (international). The volatility on the other hand is a matter of great difficulty to estimate but most times is based on the future cash flows estimable the borrower shall realise within the tem of the loan.
This is the biggest factor that the lender usually looks at as this is the only item that the borrower can really manipulate in his/her favour. However, future cash flows are very subjective using varying assumptions which must be discounted by the lender. Some of the issues that lead to discounting of the future cash flows is the estimated growth of the country as a whole i.e. GDP growth rate together with rate of default by borrowers in a similar business.
Uganda has had a poor growth rate in the past year and at the end of the financial year 2011 in June, the country could only boast of 6.3% GDP growth rate. Much as this rate is much higher than those posted in most European states and it must be known that the inflation at the time was still over 20% and today though it has reduced significantly to 11.9% it is still way over the GDP rate. This without saying erodes any gains made.
The default rate on loans over the period has also increased significantly from 2.2% in 2011 to slightly lower than 4% in early 2012. This being an industry average means not all banks are affected similarly and neither are the sectors to which these loans have been made.
That said, it shows why the banks have been more than cautious to reduce their rates regardless of the endless calls from the Governor of Bank of Uganda has urging them to reduce their rates.
A borrower thus has to consider factors which may lead to movement in his credit risk which will definitely impact on the rate at which he can borrow. Some of the factors may be exogenous and very much out of control of the borrower. However there too are endogenous and which the borrower needs to consider at length and manipulate in his favour to enable lower his risk profile and attract lower interest rates from the banker.