ON THE EFFECTS OF STATUTORY INTEREST RATE CEILINGS: COMMENT

Abstract

A RECENT ARTICLE by Avio [1] presented a theoretical model of the loan market which suggests that an increase in legal loan rate ceilings will not necessarily expand the availability of consumer credit. If true, his result could have important policy implications. However, his model contains deficiencies that make any policy conclusions drawn from it highly suspect and potentially misleading. The problem with the Avio paper is that it is a micro-economic analysis that applies to a single firm with an unrealistic capital constraint. That restraint lets a firm obtain all the capital it wishes at a fixed rate, z, so long as it maintains a minimal cash dictated by its financier. If it does not maintain the minimum required cash reserve, its borrowing rate becomes infinite.' The firm's cash reserve requirement depends on expected portfolio losses, portfolio variance, and a constant. The requirement is curious in that it does not explicitly depend on the financier's expected return, which presumably equals z times the amount of capital extended by the financier. Consequently, Avio does not allow his financiers to lower reserve requirements in order to increase their mean expected returns-in spite of the fact that he does note that some (non-risk-averse) equity-holding financiers might lower reserve requirements in the event that greater portfolio variance existed in order to take a chance on realizing a greater return. The lack of a feedback between the financier's expected rate of return, the cash reserve requirement which the financier imposes on the firm (to reduce his risk), and the amount of capital that the firm is able to obtain from its financier is unrealistic and severely weakens the applicability of Avio's model. In the real world many financiers might be willing to accept slightly more risk in order to increase their expected rate of return or, if not, a firm might be able to change financiers (if it desired) in order to find one that would accept more risk in return for an increased rate of return. In Avio's model, where the amount that can be borrowed at capital cost z is determined by the financier, the firm is basically operating under a potential fixed capital constraint. If the firm is loaned-up, i.e., borrowing as much as it can from a (non-equity holding) financier at rate z while still meeting its cash reserve requirement, it can expand its high-risk loans only by decreasing its holdings of lower yielding, but lower-risk, loans. Elsewise, cash reserve requirements would