I was thinking about this topic in the shower the other day. You’d be surprised at how often this happens.
Anyway, anecdotes aside, it occurred to me that most of us (myself included) just blithely accept that the Reserve Bank’s adjustment to the base interest rate will somehow affect us. It has to. I mean: credit cards and stuff.
There’s this blurred mental image of loose linkages: something about interest rates and banks and the National Credit Act. Maybe some outrage over furniture dealers and their absurdly high hire purchase contracts. Just a general fuzz of words and terms and newspaper headlines. But somehow *waves hands around in front of face* it’s all connected.
But I dislike haze. Clarity – I like clarity.
So let’s talk.
How does the SARB changing the Repo make FNB change Prime?
It’s one of the most curious things. Reserve Banks do not command commercial banks to change interest rates – it just sort of magically happens.
It works as follows:
- When you deposit money at the bank, most of it will be taken and invested by the bank in short-term government securities (temporarily).
- When the bank decides to lend some of your money out, it will sell a few securities, and lend the money on.
- And not necessarily in that order. The bank will have a stock of reserves (in the form of government securities) held at the Reserve Bank – and it will buy and sell these as necessary.
- There is also a set limit below which those reserves cannot fall (the reserve requirement).
- It’s a bit of a simplification, but that’s more or less the deal.
- Who does the bank buy and sell government securities from?
- Answer – the Reserve Bank.
- And at what price?
- The price is calculated based on the Reserve Bank’s set Repurchase Agreement Rate (that is: the Repo rate).
- The Repo Rate is essentially a discount rate on short-term securities (eg. if the security entitles the holder to R100 to be repaid in 3 month’s time, then a Repo Rate of 5% will mean that the Reserve Bank will buy that government security for R98.75* from the commercial bank).
*R100 × [1 – (5% × 3 months/12 months)]
So all of a bank’s activities are intrinsically-linked to the Repo Rate. And the banks make money by offering us deposit rates that are less than what they earn from the Reserve Bank; and by lending us money at rates that are higher than what they pay to the Reserve Bank:
But that alone does not explain why Prime shifts with the Repo rate. Obviously, if the rate of Repo rate goes up, then the banks are really quick to increase lending rates (otherwise, they’d lose money). But why increase the rate that they offer on deposits?
The answer to that is simply “competition”. When the Reserve Bank raises the Repo rate, every bank can afford to offer better deposit rates without being worse off. If, say, FNB doesn’t follow suit, and keeps deposit rates low, then it will start to lose customers to the other banks. And because losing depositors is terrible news for banks (it means less loans, which means less money), everyone just takes it on the chin before the fight begins.
Of course, it doesn’t always happen that way. Especially when you have reserve banks like the ECB trying to cut rates to near zero – the banks sometimes just rebel and refuse to lower their interest rates in kind. Either that, or they just refuse to lend out money (the proverbial “credit crunch”).
And this Prime “plus a factor” situation on my mortgage?
Prime acts like a benchmark. It’s the rate at which a bank will lend to a “prime” borrower, being someone with a good credit history, good job, and good collateral. But, obviously, not all borrowers are created equal.
If you have a good credit history, a reasonable income and some collateral, then maybe you’d have a low factor (like +1% or something). And if you’re a super-awesome borrower (notably – bank employees, because the bank controls their paycheck and collection is real easy), you could probably get an interest rate that’s below prime (a negative factor).
If you’re a bit riskier, then your prime factor might get quite high. And then, eventually, you get the people whose financing is denied until they return with a reasonable credit history and a solid payslip.
It’s why we need credit cards. For the credit history.
I did actually mean to write about how this ripples out into the rest of our lives. But I’ll leave that for next week.