How Low interest rate can be bad for small business - 2

In a 2012 post with same title, How Low interest rate can be bad for small business, I had explained mechanics of how small businesses are denied capital BECAUSE of lower interest rates. This was summarized from my book Subverting Capitalism and Democracy. Over the years few readers have asked for further explanation. So here goes.

Demand for projects

Let us look at the following schematic.

Capital Quantum and return

The diagram shows the amount of capital demanded and its possible rate of return. The distribution is made from capital requirements of various businesses of various sizes. The financed part is the blue rectangle. The width of this rectangle and its location is determined by various factors.

Now our experience tells us following details - (1) smaller businesses have higher risk profile whereas larger businesses have lower risk profiles; (2) smaller businesses have smaller quantum requirement whereas larger businesses have diverse capital needs; (3) as a corollary projects with large quantum of capital requirement and low return are dominated by large corporations.

Therefore, let me quote what I said earlier:

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.

The Mechanics

When interest rates are low this rectangle starts more towards the left. This is space where there are weak business models, those that are viable only in low return scenario. This space has irrational mega-projects of large businesses like debt financed share-buybacks etc. With the superior credit rating of large businesses these projects crowd out the smaller businesses.

As the interest rates rise the rectangle is pushed rightwards. 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. 

Are few projects with consortium lending more risky?

The answer to this question is easy if you understand it from banks perspective and not from bank manager's perspective. From bank's perspective more the number of projects it finances the more the diversification possibility and thus lesser the risks.

But this has higher risks for bank manager who has to stick out her neck for each of these projects. From bank manager's perspective fewer the projects and more the number of borrowers approving the project as credit-worthy lesser the risk for bank managers. But this means more the risk for the bank (concentration risks).

In sum

The cumulative effect of all these is that at low interest rate the credit is denied to small borrowers at the expense of irrational mega-projects of large businesses. When the interest rates rise, as they always do, these projects turn bad and become a drag on the economy.

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Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".