Interest rates and risk premiums
What the Basel Accords get wrong
By Oliver Pahnecke
The Basel Accords are an attempt to make financial markets more resilient. This article[1] argues that the Basel Accords confuse price and property, a mistake that leads to incorrect price discovery for loans, as well as to increased prices and risk in lending. Its argument is based on the analysis of the legal character of risk premiums in the interest rates of loans, and argues for the reduction of risk premiums in accordance with the real default risk that usually diminishes over time.
In 1974, a major West German bank, Bankhaus Herstatt, collapsed. In response, the Basel Committee on Banking Supervision developed the Basel Accords, which aimed at improving risk management. As the value of collateral varies widely across borders, its use to compare counterparty risk was limited, and weighted risk was introduced by 1988 instead. This meant that risk was supposed to be expressed as a percentage which was then included in interest rates. The application of weighted risk started in the 1990s, and by now, its use has become ubiquitous, as it has been implemented in all major economies and most states dealing with them.
Weighted risk does not only help with the comparison of risk, it also makes loans more widely available: weighted risk means that borrowers will have to pay interest, and on top of that, a risk premium that corresponds with the individual risk of the borrower. This increases the interest rate, and along with compound interest, it accelerates the repayment of the principal. A comparison of identical loans that differ only in the risk class shows that high-risk borrowers with a high risk premium repay the principal far earlier than low-risk borrowers who pay the lowest risk premium, on top of the prime rate (the lowest interest rate available).[2] This makes economic sense, because low-risk clients put up excellent collateral that serves as the protection of the lender’s payment claim in case of a default. In such cases it does not really matter for the lender, if the principal is in the hands of the borrower for a long time.
Should lenders agree to lend money to a riskier borrower, however, it makes a big difference if the principal remains with that borrower for a longer period. If the duration for the repayment of the principal is compared between the different risk-classes, it becomes clear that the risk premium not only accelerates the repayment. It also shortens the period of time during which the property of the lender, the principal, is not protected by any or only poor collateral.[3] This is reflected in lending practice: if the borrower has good collateral to offer, the risk premium and therefore the interest rate is low. In cases where the borrower has only poor collateral to offer or none at all, the risk premium will be higher.
This means that collateral and risk premium can be exchanged. And if they can be exchanged, it means that they have the same function, the risk premiums are a new kind of collateral, a collateral sui generis.
But if collateral and risk premiums are exchangeable and have the same function, why do lenders have to return only collateral to their low-risk borrowers, while they keep the risk premiums of high-risk borrowers? To answer this question, it is necessary to analyse what the risk premium offers or does, in order to justify its existence.
The general justification for the risk premium is that it is allegedly the price for risk. Yet, anti-discrimination law prohibits prices that differ in accordance with the client’s characteristics. For example, in most health systems, health insurance policies must not differentiate between women and men just because women might eventually cause higher costs due to pregnancies. As research shows, the prohibition of discrimination against individuals can also apply to social status and financial capacity, in other words – risk – and it can be applied to corporations as well as states.[4] Discriminatory pricing is therefore excluded for risk in loans.
The risk premium cannot be an insurance either, since there is no third party involved as an insurer and the financial industry has developed other instruments to hedge against risk. Nor can the risk premium be used for mixed calculations, because this would reduce market discipline that is supposed to encourage prudent behaviour.[5]
The risk premium serves as a protection of the lender’s property, the principal, like any other collateral. As illustrated above, it protects the principal by increasing the rate of repayment through the combination of interest rates with the risk premium and by compounding both. This way the risk premium reduces the time span at the beginning of the loan when the principal is poorly protected. Since a default or bankruptcy at the beginning of the loan contract is less likely than later, lenders regularly agree to use a risk premium instead of a collateral, where necessary.
It goes without saying that lenders have the right and even the obligation to protect their property, the principal. But the present approach of keeping the risk premium appears to protect the lender’s property at the expense of the borrower’s property, if the risk premium is the same thing as a collateral:
Currently, risk premiums are considered a part of the price, as they are included in the interest rate and are treated as the property of the lender. This, however, does not make sense. The price for the loan that every client has to pay to obtain a loan for a period of time, before the risk premium is added, is the interest rate called “prime rate”, which depends on the market. Based on constitutions and international treaties, only previously and legally acquired property is acknowledged and therefore legally protected. Accordingly, only the principal enjoys full constitutional protection, while the interest rate as the market-driven price that might be paid by a client in the future, does not. Only once a client pays the price, the interest rate turns into the property of the lender.
Thus, the risk premium is different from the interest rate and the principal. As a collateral sui generis, it is and remains the legal property of the borrower which can only be utilised by the lender in case the borrower does not fulfil the obligations of the loan agreement.
This legal differentiation between the lender’s property (the principal), the price of the loan (the prime rate), and the borrower’s property (the risk premium or collateral) is important because it shows the current practice confuses price and property.
To reconcile the right and obligation to protect the lender’s property with the prevention of discriminatory pricing that also would mean an expropriation of the borrower, the risk premium needs to be adjusted in accordance with the real risk:
Before the full repayment of the principal, when the lender’s property is only insufficiently protected, the risk premium is justified and has to be borne by the riskier borrower, in return for obtaining the loan despite the higher risk he poses to the lender’s investment.
After the full repayment of the principal, when the counter-party risk has dropped to zero, the risk premium must be adjusted because there is no more risk for the constitutionally protected principal. This approach guarantees initially risky but prudent borrowers the same prime rate at the end of the loan contract as the low-risk clients, preventing discriminatory pricing and today’s confusion of price and property.
Should risk premiums be treated as collateral against the current practice, it is improbable that lending to riskier borrowers would become unavailable, it would rather be conducted more prudently. This reform would not require additional regulation because the Basel Accords already demand the evaluation of risk quarterly or even more frequently, if the market conditions so require.[6] Hence, the data for the risk-adjustment is already available. Treating the risk premium legally as collateral does not constitute price regulation but increases competition in a free market, instead. On the other hand, regulators would have to ensure that the reform is implemented smoothly so that financial institutions are not unnecessarily exposed to the risk of bankruptcy, as a hasty introduction could otherwise lead to a reduction of competition.
As risk premiums would have to be adjusted, lending would likely become cheaper, helping private households, the productive economy as well as states immediately. But while financial institutions would earn less since they would have to release the collateral sui generis, also they should benefit in the long term: from less risk in the financial system, fewer bankruptcies and an overall increase of stability. Moreover, although the windfall profit caused by the lenders’ current practice to keep risk premiums would shrink, one should not forget lenders also operated profitably before the introduction of weighted risk in the 1990s. Prudent lending and reduced risk would hopefully lead to less moral hazard triggering expensive rescue measures that would have to be borne by the whole economy. Finally, lower natural prices for risk should not only reduce prices overall, but it is likely that the need for QE and negative interests would be reduced.
This article is a summary of Pahnecke, O. and Bohoslavsky, J. P. (2021) “Interest Rates and Human Rights: Reinterpreting Risk Premiums to Adjust the Financial Economy“, Yale Journal of International Law Online.
For an explanation of the acceleration and a comparison of identical loans with different risk profile, see Pahnecke O, Bohoslavsky J P “Interest Rates and Human Rights: Reinterpreting Risk Premiums to Adjust the Financial Economy“, the Yale Journal of International Law Online, April 19 2021, Chapter III. C. “New Approach Part 1: The Risk Premium as Collateral Sui Generis” p. 18 – 21
In the comparison of three identical loans, high-risk borrower B paid 7.25% for the same loan that cost low-risk borrower A only 1.75%. The difference of 5.5% translated into borrower B repaying the principal seven years earlier to the lender in comparison to low-risk borrower A.
Pahnecke O, Bohoslavsky J P “Interest Rates and Human Rights: Reinterpreting Risk Premiums to Adjust the Financial Economy“, the Yale Journal of International Law Online, April 19 2021, Chapter III. C. “New Approach Part 1: The Risk Premium as Collateral Sui Generis” p. 31 – 41
Matthew D. Diette, How Do Lenders Set Interest Rates on Loans? A Discussion of the Concepts Lenders Use to Determine Interest Rates, FED. RESERVE BANK OF MINNEAPOLIS (Nov. 1, 2000), <https://www.minneapolisfed.org/article/2000/how-do-lenders-set-interest-rates-on-loans>
Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 (revised November 2011), II. A. 1. 98. §§ 25(I) & 61 Revised metric to better address counterparty credit risk, pp. 30-31, available at https://www.bis.org/publ/bcbs189.pdf
Oliver Pahnecke is an expert at the Information Security Institute and a Ph.D. candidate at Middlesex University.