The Impact of Interest Rates on Loan Markets
Prevailing interest rates have an immense effect on everything from consumer borrowing costs to stock market values. Higher interest rates make borrowing more costly and can slow the economy; but they can also offer benefits to savers.
Online banks tend to offer higher yields on savings accounts than traditional depository institutions.
Supply and Demand of Credit
The credit (or loan) market is where individual households provide or request loans from one another. When real interest rates increase, borrowing becomes more costly and demand for loans drops; as lending money involves risk; lenders demand a premium called “interest” for taking on such an obligation.
High interest rates mean borrowers will pay more when borrowing money, leading to reduced spending and slower growth. On the other hand, however, higher rates can benefit savers by earning more on their savings; this may increase investment returns in emerging markets such as Russia or South Africa. Unfortunately, however, their effects tend to be short-lived; soon other factors outside the loan market will influence them once again; examples include:
Inflation
Interest rate hikes make borrowing money more costly for businesses and consumers, curbing spending and hampering economic growth. Conversely, when interest rates decrease it makes borrowing cheaper encouraging spending and spurring economic expansion.
Inflation devalues money and makes repaying debt harder, which is why governments and central banks usually strive to maintain low inflation levels so as to not diminish citizens’ purchasing power.
When the Federal Reserve raises interest rates, they also raise key borrowing rate benchmarks that affect mortgage loan rates, credit card APRs and various consumer and business loan products. Rising rates tend to limit money availability within the financial system and thus limit its availability for lending. A study from UBC Sauder revealed that lenders most exposed to inflation reduced household lending which resulted in decreased housing prices and construction jobs.
The Federal Reserve
The Federal Reserve’s decisions on interest rates can have an enormously consequential effect on our economy. Their moves influence everything from consumers’ costs of financing their homes, cars and credit card spending to stock market volatility and inflation.
Cheap borrowing costs motivate companies to expand their teams and invest in new projects, while expensive rates disincentivise large purchases. The Federal Reserve chairman is one of the country’s most powerful figures; markets react immediately when he speaks.
The Federal Reserve’s primary task is to foster economic conditions that foster progress toward its dual mandate of full employment and stable prices, with one way being through regulation of and oversight for banks through regional Federal Reserve Banks. Their rules and policies result from complex interactions among political and financial stakeholders; some examples being regulations for bank practices as well as capital requirements.
Taxes
Interest rate hikes drive up borrowing costs, especially for investment purchases such as stocks or debt payments. But rising rates also bring with them additional earnings on savings and investments.
IRS monitoring’s adverse effect on loan spreads is consistent with its hypothesis of decreasing information asymmetries and thus increasing borrower bargaining power. Lesser information asymmetries enable borrowers to more competitively access alternative sources of external financing such as public markets or other banks.
To test this hypothesis, we use the Ishihara tax as an exogenous source of variation in the information environment. We find that corporate borrowers more exposed to Ishihara taxes through existing banking relationships tend to exhibit lower leverage, less bank debt, and increased bond financing compared with those less exposed. Furthermore, its impact is amplified when banks are audited by IRS.
