Value & Capital, CHAPTER XI, Section 2

This section examines factors that determine the rate of interest on loans.  Given the conclusions of the previous section, the focus is on money rates of interest.  Loans -- even those made at the same time -- may have different interest rates.  There are two main reasons for these differences:  (1) differences in the length of the loan period and schedule of repayment; and (2) differences in the risk of the borrower defaulting on the loan.  According to the author, the second of these reasons "is responsible for the element of 'risk premium' in interest rates as generally understood."

A borrower judged to have poor credit will have to pay a higher interest rate than a borrower with good credit.  This is because of the extra risk that loaning to such a borrower imposes on a lender.

[E]ven if the supposedly untrustworthy borrower does discharge his obligations, he will not pay more than he is obliged; that sets a maximum to the receipts which can be expected by the lender; all the possible variations from it are in one direction.

Therefore a lender will only be induced to lend to a less sound borrower if he is offered better terms than for a loan to a sound borrower.

A borrower's creditworthiness is a matter that individual lenders must subjectively assess.  These types of judgments are likely to vary among lenders.  For a small loan, a business may find it possible to raise the desired amount of funding "by appealing only to that inner circle of potential lenders with which it has good standing, and who thus may be expected to be willing to lend to it on relatively favourable terms."  To raise larger amounts, the business must either appeal to other lenders, who will want a higher rate, or else persuade lenders in the "inner circle" to lend more.  The amount that a particular lender will loan is limited by that lender's willingness to incur risk from "putting all his eggs in one basket."  Offering better terms (such as a higher rate of interest) not only persuades an individual lender to lend more, but it also induces additional lenders to be willing to lend.  The result of this effect is that

Each particular borrower thus finds himself confronted with a sort of 'supply curve for loan capital', analogous to the supply curves of other factors of production which confront a producer when he is in a 'monopsonistic' (or monopoly buyer) position.

The section closes by noting that there is no reason to suppose this supply curve would be perfectly elastic.  Although the author does not go into detail, he notes in passing that "this consideration introduces into the theory of interest questions analogous to those which have been discussed by writers on Imperfect Competition," which a complete theory of interest ought to take into account.