The mystery of the prime lending rate

Forget about the Kruger Millions or what caused the Helderberg disaster, South Africa’s greatest unsolved mystery is why the Reserve Bank continues to tolerate the use of the so-called prime lending rate by commercial lenders as a benchmark for extending loans to customers.

Step into a branch of any of SA’s big four lenders – Standard Bank, Absa, Nedbank or FNB – and any interest rate they quote will be linked to the prime rate, which currently sits at 9% or 3.5 percentage points above the Central Bank rate of 5.5%. According to the Reserve Bank, the origins of this 3.5 percentage point gap has its roots in the Central Bank’s decision to adopt a repurchase-transaction interest rate system in 1998. This repurchase-based system resulted in the gap between the repo and prime lending rates being set at 350 basis points, a differential the Reserve Bank says “was appropriate in the prevailing market conditions.”.

Fair enough, but what’s less understandable is why this interest rate differential has remained set at 350 basis points since September 2001 and why it has become universally accepted as the benchmark borrowing cost for the man in the street.

For those of you who don’t know how the interest rate market works, the basic workings of the Central Bank’s repo rate system are as follows: The Central Bank lends money to commercial lenders at a particular price, or interest rate. The commercial banks then give the Reserve Bank Treasury bills as collateral for the money with the agreement that they will repurchase the securities at slightly higher rate. This repurchase rate thus becomes the Central Bank rate, currently at 5.5%.

Commercial banks then loan the money they’ve borrowed from the Reserve Bank at 5.5% to customers at a higher rate, pocketing the difference as profit. The mystery is why all commercial banks are allowed to use an imaginary prime rate that’s a full 3.5 percentage points higher than the repo rate as a reference point for pricing their loans. Banks argue that since certain customers are granted loans at prime less a few percentage points (and indeed others receive ‘`prime plus’ loans) the prime rate should not imply a fixed net interest margin of 3.5 percentage points for commercial lenders. However, if that’s true, then why do all of SA’s financial institutions link the cost of loans to this so- called prime rate? Surely, if there were true competition in the banking sector, they would be quoting loans at the repo rate plus a margin? In other words, if Bank A offers you a loan at repo plus 3.5 percentage points (9%) you can go to Bank B offering repo plus 3.2 percentage points (8.7%) or Bank C offering repo plus 3 percentage points (8.5%).

When Finweek put this question to the Reserve Bank, we were forwarded a document produced jointly by the Central Bank and the Banking Association of SA following a meeting in May 2009 that was meant to address this very issue. The document is interesting if only for the banal justifications given for persisting with the prime rate.

The banks’ main argument is that if they are required to price their loans based on repo plus a margin, rather than prime, the effect would be that lenders would end up quoting different prime rates. So what, I hear you ask, yet the banks argue that this “will be less transparent to consumers”.

Really? Surely it would be far more transparent than quoting a borrowing cost referenced off of an imaginary prime rate that gives banks an immediate 3.5 percentage point net interest margin to work with?

The only logical explanation for banks’ opposition to pricing loans off of the repo rate is that it would increase competition, thereby trimming their profit margins. If you think that’s an exaggeration, bear in mind that a few basis points on a R1.5m mortgage can work out to hundreds of thousands of rand over the course of a single 20- or 30-year agreement. Consider too that net interest profit typically accounts for about 50% of banks’ total income.

It’s thus far more cosy for them to continue pricing loans off of a prime rate that’s a full 63% higher than the Central Bank rate. No wonder banks are so universally loathed.

*To see the Banking Association’s Response click here.