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IAI Actuarial Core Principles · Business Economics · Pricing strategies in the financial services sector

A bank lends to small businesses without knowing each borrower's true default risk. To protect itself, it raises the interest rate for all borrowers. Why might this lower the bank's expected profit beyond a certain rate?

Higher rates drive away safe borrowers first, leaving riskier ones, so the average default risk of the pool rises. Beyond some rate the increased defaults outweigh the extra interest, reducing expected profit. This adverse selection can lead banks to ration credit instead.

  1. AHigher rates raise the number of safe borrowers, who repay more
  2. BHigher rates deter safe borrowers more than risky ones, worsening the average quality of the borrower poolCorrect
  3. CHigher rates are fixed by regulation, so the bank cannot respond
  4. DHigher rates make collateral irrelevant for all borrowers
  5. Higher rates reduce the bank's cost of funds

Explanation

Safe borrowers with modest-return projects drop out as rates rise, while risky borrowers, who gain more from success and lose limited amounts on default, remain. The average default risk of the pool rises, which can reduce expected profit and leads to credit rationing.

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