Economic Rationale for Interest Rate Adjustment Clauses in Loan Contracts

As of 1997, private adjustable-rate loan contracts must be provided with a clause governing interest rate changes which meets the requirements of the Consumer Protection Act. This legal stipulation is of particular importance for private loans granted by banks and for loans to individuals. More than two-thirds of all private loans granted by Austrian banks provide for variable interest rates and are thus subject to fluctuation mechanisms which need to comply with the relevant provisions of the Consumer Protection Act. Most of the private adjustable-rate loans granted by banks since 1997 include an interest rate adjustment clause according to which any change in the interest rate needs to be based on the arithmetic mean from the Vienna Interbank Offered Rate for three-month funds or (as of the start of Monetary Union) the Euro Interbank Offered Rate for three-month funds and the secondary market yield for federal bonds. Empirical evidence obtained from simple correlation and regression analyses supports the assumption that the standard rate covenant fully complies with the relevant criteria of the Consumer Protection Act ("factual justification" or "independence from the entrepreneur's will"). The change of the average obtained from the two interest indicators reflects to a high degree the development of average refinancing costs by the Austrian banks since the mid 1990s (for database reasons, a comparison with the period before 1995 is not possible). An attractive and relatively simple theoretical approach to justifying the standard rate clause is provided by interpreting it as a rule for sharing macroeconomically caused interest rate risks. Assuming approximately risk-neutral banks, this adjustment mechanism warrants that the non-diversifiable macroeconomic risk of a change in the interest rate is optimally spread between approximately risk-neutral borrowers and investors. In the given context of the model, an optimal situation for all players involved is obtained when banks on balance carry no risk, whereas the borrower and investor share the macro-economic risk of a change in the interest rate at equal parts. Near-risk-neutral banks carry the macroeconomic risk of a change in the interest rate (at 50 percent) only when the borrower and investor belong to different risk preference categories (e.g., the borrower is averse to risk and the investor is more or less risk-neutral, or vice versa).