Thursday 21st April 2005


Are banks’ rate hikes justified?

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By Jwala Rambarran,

Chief economist, CMMB

Commercial banks have started to raise their prime lending rate to nine per cent from 8.75 per cent, attributing the hike to the recent decision by the Central Bank to increase the repo rate by 25 basis points to 5.25 per cent in the face of rising inflationary pressures.

The logic of this argument seems flawed as the repo rate stood at five per cent for over one year with absolutely no effect on banks’ lending rates.

While we might be seeing an end to the Central Bank’s accommodative monetary stance, which was put in place since September 2003 to help stimulate growth in the non-energy sector, the reaction by commercial banks to hiking prime is not justified in the context of current and evolving financial conditions.

Prime is supposed to be the interest rate at which banks lend to their best customers, those with an excellent capacity to repay and whose chances of default on loans are minimal.

Given the chronic and persistent excessive liquidity conditions prevailing in the system, coupled with ever-increasing levels of competition (First Caribbean International Bank being the latest entrant), ALL the commercial banks have been compelled to lend below their “quoted” prime rates to their best customers.

Thus, the prime lending rate has become less relevant as a benchmark for interest rates in the financial system and is now only interpreted as an “indicative” rate. More importantly, however, is that the fall in prime witnessed over the past 18 months reflects the impact of the Central Bank’s fairly aggressive schedule (relative to previous attempts) aimed at lowering the cash reserve requirement in order to compress interest rate spreads, which have been considered quite wide for a competitive financial system.

The third and final phase of this reserve reduction entails a two percentage point reduction which, when implemented later this year, will bring the cash reserve requirement for banks to nine per cent, on par with that for non-banks.

The first two reductions in the reserve requirement led to a fall in lending rates but as deposit rates also fell, albeit at a slower pace, the ensuing contraction in banks’ intermediation margins were far less than expected.

With the first reserve reduction, commercial banks negotiated a 200 basis points fall in the prime lending rate to 9.50 per cent in late 2003.

Subsequent to the second reserve reduction, they negotiated a much smaller 75 basis points fall in prime to 8.75 per cent in October 2004. Surprisingly, deposit rates began to edge down rather than upwards, negating the anticipated compression in spreads.

For instance, interest rates on six-12 months time deposits declined by 37 basis points over the past year. As a result, banks’ interest spreads contracted to 5.44 per cent from 7.82 per cent, a decline of only 238 basis points and much less than the fall of 700 basis points in the cash reserve requirement.

One must be mindful, however, that the narrowing in banks’ interest spreads cannot be interpreted as an erosion of their interest income levels. This is because commercial banks were more than adequately compensated for any potential fall in interest income through special bond issues carrying attractive returns.

With the first reserve reduction, the Central Bank released $640 million to the banks through a 15-year bond issue carrying an interest rate of 6.2 per cent. The second reduction saw some $516 million in funds freed through a 10-year bond at a rate of six per cent. Therefore, on an annual basis the banks are now collecting more than $70 million in interest from the Government on the freed up $1.1 billion in funds that they previously earned ZERO per cent on as part of their statutory reserves. Furthermore, they can now use these sizeable resources, which were previously locked away at the Central Bank to aid in credit creation and to generate additional interest income.

Indeed, the downward trend in lending rates has provided a boost to private sector credit expansion, which rose by close to 30 per cent in the first ten months of 2004 following rather sluggish growth of 4.5 per cent in 2003. At the same time, the financial system continues to be plagued by excess liquidity which suggests that interest rates should at least remain stable or trend downwards.

In the first half of fiscal 2005, Central Bank transactions have already mopped up $2.6 billion of core liquidity through open market sale of treasury notes. Sales of foreign exchange to the commercial banks would have absorbed additional liquidity. The fact that inter-bank interest rates continue to generally trade outside of the operating corridor set by the Central Bank is another indication of the liquidity overhang evident in the banking system.

In summary, the banks have little, if any, justification for increasing the prime lending rate. One could hazard a guess that, consequent on the final reduction in the cash reserve requirement, they would lower prime back to around 8.75 per cent and claim that they have effectively lowered the cost of lending while reaping further gains on interest income from the released funds.

Competition from other emerging players in the financial system is one sure way of mitigating what some may feel is an abuse of market power; not to mention downright greed. More effective use of moral suasion on the part of the Central Bank is another.

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