It may thus alter the credit premium that banks charge on loans over and above the rate at which they can collect funding. 4 The net effect of financial innovation on the balance sheet channel is somewhat ambiguous. On the one hand, new tools to assess the creditworthiness of borrowers might have contributed to compressing the external finance premium.
Also, and perhaps most importantly, credit premium determination might have become largely independent of the creditworthiness – and the value of collateral pledged by – individual borrowers. The explosion of sub-prime loans is a very telling example of this tendency of credit terms to become disconnected from the credit history and the balance sheet position of borrowers.