The determinants of the lending interest rate in a cost-based approach: Theoretical model and empirical analysis

We develop a mathematical model to determine the lending interest rate applied by a financial institution in a cost-based approach. Our model mathematically isolates the four main components of the total cost of credit, including net operating costs, weighted average cost of funding, cost of risk and weighted cost of equity. Our equations enable us to determine the floor interest rate, which is the minimum interest rate that a financial institution should set for its credit operations to be profitable. The results of the empirical analyses carried out over a 15-year period, from 2004 to 2018, corroborate the suggestions of our model that interest rates follow the evolution of the floor interest rate. One of the contributions of our model is that the results can be useful in policies that seek to improve the credit conditions of financial institutions by reducing their credit costs rather than imposing low interest rates to them. (C) 2021 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.

Automated summary

Researchers have developed a mathematical model to determine lending interest rates for financial institutions based on cost considerations. The model isolates four key components of credit costs and allows for the determination of a minimum interest rate for profitability. Empirical analysis over a 15-year period supports the model's suggestions that interest rates follow the floor interest rate. The model's contribution lies in its potential use in policies that aim to improve credit conditions by reducing credit costs rather than imposing lower interest rates.