Interest Rates and the Design of Financial Contracts

Michael R. Roberts; Michael Schwert

doi:10.3386/w27195

Interest Rates and the Design of Financial Contracts

Michael R. Roberts & Michael Schwert

Working Paper 27195

DOI 10.3386/w27195

Issue Date May 2020

Revision Date January 2022

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.

We thank Patrick Bolton, Urban Jermann, Craig Leonard, Yueran Ma, Mark Mitchell, Christian Opp, Bill Schwert, Daniel Streitz; seminar participants at the University of British Columbia, the University of Nebraska-Lincoln, the University of Southern California, and the Wharton School; and participants at the Chicago Junior Finance and Macro Conference, the Conference on Financial Frictions at Copenhagen Business School, and the Washington University Corporate Finance Conference for helpful discussions. We also thank Bilge Yilmaz for assistance in acquiring leveraged loan data. We gratefully acknowledge financial support from the Jacobs Levy Equity Management Center, the Rodney L. White Center, and the Wharton Financial Institutions Center. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
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- online appendix
- May 19, 2020

Interest Rates and the Design of Financial Contracts

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