In the case of asymmetric information, the lender must include the risks arising from the debtor’s creditworthiness, which cannot be accurately assessed, in the interest rate. This is because – the lender must protect itself against overreaching on the part of the debtor; – there are costs for monitoring, evaluation and collection (collection of claims in the event of a breakdown in the credit relationship); – the borrower could turn to less profitable exposures due to the problems of adverse selection. The financing premium therefore charged is arithmetically the difference between the cost of equity financing and debt financing. – If the firm can pledge assets to the lender, then the financing premium will approach zero. – If a company’s profits decline in the business cycle, then lenders will charge a higher interest rate. This is because the borrower’s credit rating now declines, and the risk of loss to the lender increases. – See adverse selection, agency problem, house bank, information, asymmetric, moral hazard, adverse selection, principal-agent problem. – Cf. Monthly Report of the Deutsche Bundesbank of July 2002, p. 44, Monthly Report of the Deutsche Bundesbank of January 2012, p. 15 f. (on the external financing premium; references).
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