WASHINGTON -- Banks should vary loan rates with the credit risk posed by a borrower, Federal Reserve Board Chairman Alan Greenspan said Tuesday.
"The majority of banks are playing a losing game with their current and potential competitors by employing only one interest rate per facility for borrowers of widely varying risk," Mr. Greenspan told participants at Garn Institute of Finance conference in Salt Lake City.
A single interest rate regardless of credit risk means banks are overcharging some customers, he said.
"To the extent that banks continue this practice, the best quality customers can be expected to seek better loan terms elsewhere, leaving banks with lower and lower credit quality customers for whom banks should then have to charger higher and higher rates, in any event, to cover the greater risk," he said. While risked-based rates make sense, banks are not using them because they fear losing their best customers to other banks offering even lower rates, he said.
Also, customers forced to pay higher rates would switch to banks that don't use risked-based rates.
These concerns are valid, Mr. Greenspan said. But, banks will lose more in the long run if they fail to adopt multirate lending. Borrowers will turn increasingly to the securities market, which already bases rates on credit risk.
"We can expect the better-quality smaller borrowers to follow in the footsteps of their large corporate brethren and seek credit elsewhere," Mr. Greenspan said.
The switch also would benefit the economy, he said, because creditworthy business would know they could get credit even during economic downturns when banks often reduce lending or raise rates.
"Also, other high-risk borrowers will gain access to credit for the first time," he said. "For the borrower, credit at a higher rate than other businesses pay may be a more palatable option then no credit at all."
Banks that switch to risk-based rates must be careful not to violate fair-lending laws, he said. Race and gender play no role in creditworthiness, he added.
A switch to this system will tax regulators, he said. Rather than passing new rules, the banking agencies should rely more on examinations.
"The 'basic unit of supervision,' so to speak, should become increasingly the evaluation and stress testing of the bank's overall set of risk positions," he said, although regulators still must examine individual assets, he added.
Regulators need to learn the difference between acceptable and unacceptable risk-management techniques, he said. And, banks that take little risk, should not hold as much capital as banks that take larger risks, he said.