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 Banks
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
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
Banks 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
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
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.