Interest Rates and the Design of Financial Contracts

Abstract

We show that the partial response of loan rates to interest rate changes, referred to in the bank lending literature as ``stickiness,'' is a feature of perfect capital markets. No-arbitrage models of credit risk are able to replicate empirical interest rate sensitivities. However, the widespread use of interest rate floors in the low-rate environment of the last decade is a result of risk-sharing and incentive considerations arising from market imperfections. Floors reallocate cash flows across states in a way that loan spreads cannot. They insure lenders against losses if rates fall, while mitigating borrower moral hazard if rates rise.

Keywords: financial contracts, interest rates, banking, commercial lending

JEL Classification: G21, G23, E43, E52