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.
Garth Theunissen
gartht@finweek.co.za
It is interesting to look at the banks finacial year end results in the “thoughtest condintions for the last ‘who knows many years”. With a gauranteed 3,5% margin, plus as mentioned, no more prime minus, but prime plus, you understand why they have super profits, definitely not reflective of the though conditions. They use the excuse, that they must cover their high risk clients from the third world sector. Then don’t lend out to the hight risk clients. SA banking clients have always been taken for a ride, by the price fixing/collusion of the banks.
@2b59f87a51e3a89859a344edf1b1f114:disqus If the `prime rate’ is misnomer then why is it used by ALL lenders in South Africa as the reference point for extending loans to customers? Secondly, the best customers in SA simply DO NOT get loans at prime less two percentage points – NOT ANYMORE THAT IS. That may have been the case prior to the 2008 financial crisis but it certainly is not the case in the current lending environment. In fact, one of the reasons banks are so reluctant to grant rate concessions right now is precisely because of the sheer amount of `prime less two’ facilities they extended prior to the 2008 crisis. With profit margins under pressure and a truckload of mortgage books filled with `prime less,two’ facilities, banks are actually penalising current borrowers to cover their losses/and/or meagre margins being made on loans extended prior to the financial crisis. But if you still think the prime rate is a misnomer, why not walk into any of our big four banks and ask for a loan…then come back and tell us what interest rate they offered you.
Except that “prime is a misnomer”. Top customers here get at least prime MINUS 2 on their mortgages, and better than prime on their facilities.
Good work and thanks for a lucid critique
Fantastic article. We MUST expose our banks for their excessive bonuses, their collusion, price fixing, excessive profits, excessive charges, and complete lack of service in addition. Well done, and keep up the good work. It’s time we had a REAL investigation into the banking sector and some legislative changes imposed on them to lower costs and to encourage people to save, especially in view of the savings crisis in our country.
Evelyn
Koos, the process that is used to determine the prime rate actually matters enormously. If you don’t believe me, take a R1m mortgage over say 20 years and work out how much you’d pay at 8.5% interest over that time frame (assume a fixed rate for the sake of simplicity). Then do the same calculation with a rate of say 8.2%. The difference in financial terms will be huge. Hence my argument: why do we have a situation where there is an assumed 3.5 percentage point margin for banks in SA? There is absolutely no market-related reason for this 3.5 percentage point spread between repo and prime in SA. It has simply been plucked out of thin air and applied arbitrarily to everyone. If bread producers or steel makers are not allowed to use an assumed reference price for their products without the threat of being sanctioned by competition authorities, why are banks afforded special dispensation to do so? Surely collusion is collusion – regardless of whether we’re talking bread prices or mortgage rates? I propose that SA banks be forced to assess each individual client on a case-by-case basis and that loans be priced on a `repo plus’ basis in order to promote real competition in the lending market. If you have done the calculation I mentioned above, you will see that a few basis points on a home loan can literally save you hundreds of thousands of rands over the course of 20 or 30 year mortgage. Imagine if that money were instead pumped into a unit trust? Instead, it is now going to a banking executives inflated pay package.
The thing is, what does it matter how to got to a “prime rate”? Whatever process is followed, it will end up with a profit margin for the banks. Whether the margin is excessive or not, is a separate debate.
However, banking in South Africa is still some of the best in the world, and definitely far better than in the US. In the USA, an “on-line” payment (to a recipient at another bank) is done by the sender getting onto the internet, making the payment. The sender’s bank will then print a cheque, mail it to the recipient, who then goes to his bank to deposit the cheque….
Also, South Africa did not suffer nearly as much from the recent banking crisis compared to individuals in the USA, or what individuals in Europe are still going to suffer. (Primarily in deflated property prices.)
Lastly, some states in the USA are non-judicial states: That means that the bank doe snot need to go to the courts to repossess your property. There are numerous horror stories of major US banks evicting the wrong people, or giving people the wrong advice, which results in them losing their houses.
good thinking and reasoning, this needs further investigation. This will continue to keep us consumers in a debt trap!
Good article, issues like this need to be exposed and questioned. Keep pressing the issue!