Interest rate differential

BY MARY HOLM

Q. I think you will find that the differential between interest rates on mortgagee and business loans, as discussed in last week's column, is a function of capital adequacy regulations, not costs associated with providing the loan.

Residential mortgagees require only half the amount of bank capital to support them by comparison to commercial loans, even those to AAA-rated borrowers.

A. We're both right.

I said last week that higher commercial rates would reflect higher costs and/or higher risks.

But before we go into that, others might appreciate a quick explanation of capital adequacy.

Banks in New Zealand, and in more than 100 other countries, are required by their banking supervisor (in New Zealand, the Reserve Bank) to hold a certain amount of capital relative to the amount they lend.

It is system designed to make it unlikely that they will get into financial trouble even if quite a few of their loans are not paid back.

The capital requirement varies, depending on the type of loans made.

As you say, for every dollar a bank lends on a residential mortgage, it must hold only half as much capital as for every dollar lent commercially.

Banks will consider that when setting their interest rates, says a Reserve Bank official.

In the end, though, it all comes back to risk.

Interest rates charged by banks and capital adequacy regulation are just reflecting different risk characteristics of various asset types, he says.

The default rate on commercial lending is a lot higher than on residential lending, and hence is more risky to the bank.

To compensate for the additional risk involved, a higher interest rate will be charged.

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