Leading rate in the credit market , Financial Management

LENDING RATES IN THE CREDIT MARKET

One of the crucial decisions involved while extending loans is the lending rate. Intermediaries will base their lending rate decisions on three important criteria - their cost of funds, transaction costs and the required spreads. The sources of funds will determine the cost of funds for the intermediaries. The major sources of funds to banks and NBFCs are public deposits. Other than this, the intermediaries can also raise funds from the other financial markets. Transaction costs will depend mostly on the efficiency with which the transfer of funds is enabled. All costs incurred in the decision-making process while approving a proposal and in maintaining the clients' accounts throughout the loan repayment period constitute the transaction costs. Apart from ensuring that these costs are fully covered, the lending rate fixed by the intermediaries will also include a certain percentage as a spread for making the lending activity profitable.

Though this method of pricing seems to give the lender adequate returns for the funds lent, it may not happen in all cases. In reality, the cost of lending may actually rise based on the prevailing market conditions. For instance, the transaction costs for the loan may rise during the repayment period. Further, lending is a risky business. To ensure that the profits earned by way of interest income sustains the risk exposures, the price should include a premium for the risks involved in this business.

Thus, apart from satisfying the three basic criteria for fixing the lending rates, intermediaries should also consider all the risk exposures. First and the most important risk exposure in the lending activity relates to the credit risk. Proper credit analysis of the client and the proposal is essential to counter such risks. Based on the assessment of the creditworthiness, the lending rate should be fixed in such a way that it reflects the credit risk present in the transaction.

In addition to this, lenders may also perceive an interest rate risk. In an administered interest rate environment, the scope to manage interest rate risk will be negligible/nil since the regulator fixes the rates leaving little scope for market determination. However, in a free economy, where the market forces decide the rates, the uncertainty relating to the movement in the rates will be high thereby increasing the risk and along with this comes the scope to manage it.

The lending rate can be either fixed rate or a floating rate. Generally, short-term loans have a fixed rate, while loans for longer tenure may have a floating rate. Further, fixed rate is preferred in a declining interest rate scenario, while the floating rate would be more suitable when the interest rates are sloping upwards. The floating rate will also enable the intermediary to hedge against rate fluctuations to a certain extent. However, to use the same, there has to be a proper benchmark/reference rate. Internationally, the London Inter Bank Offered Rate (LIBOR) is used as a reference rate for Euroloans, etc. In the Indian market, the Bank Rate (BR) and the Prime Lending Rate (PLR) of the banks and the financial intermediaries are used as a reference rate for loans and advances. Of these two reference rates, PLR will be the most preferred reference rate since it is market determined. The bank rate is given by the Central Bank and is not market determined.

The lending rate should thus reflect the risk exposures present in the credit disbursal. Apart from adjusting the rate charged to the risk perception, intermediaries may sometimes, based on the creditworthiness of the client, demand a collateral/security in the form of an asset/guarantee/co-obligation. The arrangement of a collateral/security is generally made to minimize loss due to default of loans. Sometimes, the amount of loan extended and the rate of interest charged will depend on the security offered for the loan.

However, in spite of credit assessment and proper pricing, if the borrower defaults, the intermediary has the option of altering the repayment schedule and make it flexible enough for the borrower to repay. Such facility is generally not available in other financial markets.

Since a major portion of the savings in the economy will be routed to the intermediaries, it will be the responsibility of these intermediaries to ensure that efficient transfer of funds takes place. Over the years, credit market has gained tremendous importance as a place for raising funds. There has been an increase in the quantum of credit extended by this market. Accordingly, there is also a rise in the number of borrowers and lenders. Both these parties look for certain issues while operating in this market.

The borrowers generally prefer to have the following features while entering into a deal:

  • Low rates of interest.
  • Minimum lead time when money is required.
  • Access to funds up to the desired period of time.
  • Minimum terms and conditions attached with the usage of funds.
  • Minimum monitoring and interference from the lender.
  • Freedom to set the repayment schedule according to the convenience of the borrower.

 

Posted Date: 9/11/2012 3:31:05 AM | Location : United States







Related Discussions:- Leading rate in the credit market , Assignment Help, Ask Question on Leading rate in the credit market , Get Answer, Expert's Help, Leading rate in the credit market Discussions

Write discussion on Leading rate in the credit market
Your posts are moderated
Related Questions
This assignment is an analysis of a U.S. publicly-traded company; its common stock could be a prospective investment. The report is due in Week 10, in needs to be at least 5 pages

discuss the applicability of operating cycle in poultry industry[consider broilers]

Question: (a) Give the four main types of financial investments and state the risks and bene ts associated to each type. (b) (i) Let k(t; T; s) denotes the return at time t

Demerits of Pay Back Method:- (i) It ignores the Cash Flows after the Pay Back Period: - The main shortcoming of this method is that it completely ignores all cash inflows subs

Determine the term- Component Cost and Composite Cost A company may contemplate to raise desired amount of funds by different sources comprising preferred stock, debentures and

Lakespring Retirement Village is home to senior citizens who are fairly independent but need assistance with basic health care and occasional meals. Jill Thompson, a licensed beaut

Cash management is about managing excess cash also. The response of management must depend on whether the surplus is large and how long it is likely to exist. If the balance is

Q. Show the Analysis of Credit Information? Analysis of Credit Information: - Subsequent to obtaining the desired information from various sources the information is examined t


Why does the riskiness of portfolios have to be looked at differently than the riskiness of individual assets? The riskiness of portfolios should be looked at differently as comp