Thursday, August 02, 2012

How Low interest rate can be bad for small business

Summarized from the book (click to buy)

We are told that when interest rates are too low, they are encouraging entrepreneurs to take risk.

However, this impacts the business models differently. At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. At the other extreme, there are weak business models, those that are viable only in low return scenario. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks. 

How low interest rate leads to mal-investment 
A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. Ideally, even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. 

However, in reality, lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. 

Typically, such irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Intelligent investors will find that this contradicts with the "diversification as risk management" strategy. But being with herd has a stronger lure and is treated as risk mitigation (though wrongly).

Further, at lower interest rates, debt starts being used as an instrument to amplify equity returns.  

Thus the second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. 

In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.