My recent article The Mystery of the Prime Lending Rate elicited much response from players in the financial industry, most of whom felt that I was being overly cynical in my analysis of the local banking sector’s use of this imaginary and completely unjustifiable reference point for extending loans to South African consumers.
For those of you who missed the article, the nub of my argument centres on the simple fact that neither the Banking Association of South Africa, nor the Reserve Bank or National Treasury has been able to explain how and why it was decided that the prime lending rate should be fixed at 3.5 percentage points above the repurchase rate. In the current environment, that means that the reference point used for extending credit to South Africans is currently set at 8.5% compared to a central bank rate of 5%. This is despite the fact that the three-month JIBAR rate, the benchmark rate at which banks borrow from each other in the open market, is currently at 5.075%.
Despite numerous requests for an explanation, none of the above-mentioned institutions have been able to explain to me how or why this 3.5 percentage point interest rate margin for commercial lenders was decided. In my most recent response to the Banking Association’s criticism of my original article on the prime lending rate, I wrote: “In the absence of any explanation, one can only assume that it was arbitrarily decided by banking executives and the Reserve Bank Governor over a few single malts and some Cuban cigars.”
Interestingly, this has never been refuted by any of the parties concerned. Yet the nagging question still remains, how and why was this 3.5 percentage point interest rate spread decided? One of the explanations I was offered by a member of the financial industry was that there’s nothing sinister about SA’s prime rate as the US utilises a similar margin for borrowers generally considered as “prime” (ie those without an impaired credit record – as opposed to sub-prime borrowers with patchy repayment histories).
On the face of it this argument is true. However, there are several fundamental differences between the prime rate used in SA and that used in the US. Allow me to explain.
The US prime rate is essentially based on the Wall Street Journal ’s survey of the rate at which the 30 largest banks in America will lend to their most-favoured clients – and herein lies the rub. In the US, the prime rate is an aggregate of the rate at which the nation’s largest banks are willing to lend to their clients, based on their individual assessment of market lending risk to “prime” borrowers. In SA, the rate has simply been plucked out of the air and used as a reference point for extending loans to everyone.
While it’s true that local banks do sometimes shave off a few percentage points off the prime rate for good clients, it’s equally true that they sometimes add a few percentage points to compensate for the perceived higher risk of others. Either way, the prime lending rate is still the central reference point from which any rate negotiation in SA begins. Moreover, in SA there exists absolutely no market-related explanation for how and why this spread was set at 3.5 percentage points.
However, the most galling difference between how the prime rate is applied in SA relative to the US is that one cannot take out a mortgage in SA and fix it at prime for the entire duration of the loan. According to Bankrate.com, the US 30-year fixed mortgage rate is currently 3.52%. One can also take out a 15-year mortgage at a fixed rate of 2.93%.
That compares to a prime mortgage rate of 8.5% in SA, which is also extended on a variable basis. In other words, even if you take out a 20-year mortgage at the current prime rate of 8.5%, any increase in the central bank rate will cause your monthly mortgage repayment to increase.
Although it’s possible to fix mortgage rates in SA, this is almost never done by homeowners because of the simple reason that local banks usually apply such a hefty premium to the prime rate when doing so that it becomes too expensive to even consider. Even with a minimal premium, it’s seldom possible to fix a mortgage rate in SA for more than a few years so the benefits of doing so are seldom worthwhile.
As I said in a recent discussion on Finweek Money Matters, which airs on CNBC every Friday at 1pm: “Banks always win.” In SA they just tend to win by a particularly hefty margin.