Q&A with CMMB Securities

Q. Commercial Banks have just lowered their prime interest rate.
How does that affect the average person and am I likely to see a lower monthly payment on my mortgage?

Vijay, Curepe

A: Commercial Prime is the rate at which banks lend money for commercial use to their best customers, that is, customers who have had a long-standing relationship and a good credit history. As you quite rightly pointed out, a couple of banks did lower their Commercial Prime lending rates. As a result, the rates on demand loans and overdrafts would go down immediately as they are linked to Commercial Prime. So individuals who have personal overdrafts and demand loans may benefit from lower monthly debt servicing once their facilities are directly linked to Commercial Prime. However, the rate on a mortgage may be directly or indirectly linked to Mortgage Prime, but not Commercial Prime as the latter applies to rates on commercial loan issues. While Commercial Prime and Mortgage Prime do sometimes move together, the latter tends to move by smaller amounts over a longer period of time.

In the past when banks reduced their Commercial Prime rates this may have been followed by reductions in Mortgage Prime, albeit by much smaller amounts. But the rates on most mortgages are fixed from inception, so even though Mortgage Prime may be reduced the rate on a fixed rate mortgage would not be affected. In order to benefit from the lower rates an individual would have to refinance his/her mortgage, the legal costs of which can be very onerous making it uneconomical. However, there may be some types of mortgages which have a floating rate structure linked to Mortgage Prime and so individuals who negotiated such facilities would benefit from a lower rate and hence a reduction in their monthly installment.
Such floating rate facilities are not common amongst individuals and so there may not be many people with existing mortgages benefiting from any reduction in Mortgage Prime, even if it does materialise.
Q. I heard that the Central Bank reduced the Primary Reserve Requirement from 18% to 14% recently. What exactly is the reserve Requirement?

Brian, Diego Martin

A: The Reserve Requirem-ent, as the name implies, is the required reserves, which commercial banks have to keep with the Central Bank as part of statutory regulations. The amount of reserves banks have to keep is calculated as a percentage of their deposit base. So if the reserve requirement was 18% a few months ago and the deposit base at that time was TT$5 billion then the cash reserves kept at the Central Bank by that commercial bank would have been 18% of 5 billion or 900 million. As the Central Bank has reduced the reserve requirement from 18% to 14%, the required cash reserves to be kept would now be 14% of 5 billion or 700 million. In other words that particular bank with a 5 billion deposit base would have its required reserves reduced from 900 million to 700 million.
 
The 200 million in funds released from the cash reserve account at the Central Bank is now available by the bank to be used for lending etc. So a reduction in the reserve requirement increases the money supply in the financial system. Conversely, if the reserve requirement had been increased then the amount the banks have to keep with the Central Bank would have increased and hence the money supply available to them for lending would have been reduced. In fact, the way in which the reserve requirement affects the money supply is the very reason the Central Bank uses it as an instrument of monetary policy. For example, if the Central Bank wants to reduce interest rates then they would want to expand the money supply. One of the ways in which to do that would be to reduce the reserve requirement releasing cash reserves at the Central Bank back into the financial system. On the other hand, if the Central Bank wanted to effect an increase in interest rates one of the ways would be to increase the reserve requirement thereby taking more money away from the banks to be housed in the Central Bank reserves reducing the money supply. Based on that it is therefore not surprising that commercial banks reduced their Prime Lending Rates in response to the reduction in the Reserve Requirement.