Banks’ policies on Repo and prime lending rates

Major international banks and non-bank financial institutions fell, shaking the confidence of the public and foundations of many economies. Others required large capital injections by their governments, leading to fiscal imbalances and growing debt portfolios in many countries.

Locally, the banking industry, while affected by the slowdown in economic activity, has been able to maintain public confidence by preserving shareholder wealth/value and ensuring the safety and security of customers’ deposits and assets.

This article addresses the interest rates charged by the banks, in particular, mortgage rates and their correlation with the Central Bank’s repo rate.

Defining the Repo and

Prime Lending Rates

Banks do not set interest rates independently. Interest rates are set in tandem with movements in the Central Bank’s repurchase rate (repo) and movements in the prime lending rate.

• The repo rate is essentially the rate at which the Central Bank is prepared to provide overnight financing/funding to commercial banks that are temporarily unable to meet their liquidity requirements and is the principal instrument used by the Central Bank to influence the structure of commercial banks’ interest rates.

• Prime Lending Rate – This is the lowest rate on loans granted to customers often referred to as “best customer’s rate”.

Further, in adherence to core banking standards, banks must follow prudent lending practices for the benefit of the industry and the public at large. Accordingly, the risk profile of the potential customer must be considered. The likelihood is that the customer who does not have a credit history or a poor credit rating will be charged a higher rate, while a long standing customer or someone with a strong credit history will benefit from better rates.

The Relationship between

Repo and Prime

The repo rate is a short term indictor and is used as a reference point for temporary financing to the banks in order to meet their liquidity requirements. It is however a widely accepted practice by central banks to use the repo as a monetary tool in influencing interest rates within the banking industry.

The prime rate is in most instances the underlying index for the rate charged to customers by the banks. Over time, movements in the repo rate would influence the prime rate of the banks as indicated in the table below.

The table shows the movement in the repo rate and the corresponding response by the banks over the last 13 months. In all instances, except one, the percentage reductions in the repo rate are matched by equal movements in the prime rate by the banks.

What does this mean

for customers?

Customers whose borrowing facilities are linked to the prime lending rate benefit from reduced rates as prime rate falls.

Local commercial banks have responded to the downward movement in the repo rate and this has translated to direct savings to both retail and commercial customers’ loans tied to prime. This means that based on the number of reductions in the prime rate throughout the period, literally thousands of customers, primarily, in the commercial and small business sectors, would have benefitted from reduced interest payments on their loans.

Mortgage Rates

The movements in the repo are an indicator of the general trend in lending rates; however, it is not a complete and accurate assessment in the context of mortgages.

Mortgage financing by the banks is long term (as much as 30 years) and remains on the books of the financial institution for a considerable number of years.

In promoting and ensuring responsible management of depositors’ funds, financial institutions attempt to match mortgages with long term deposits. However, the percentage of long term deposits is often an insignificant proportion of the total deposit liability, which means that the banks are required to carry the interest rate risk on their balance sheets in addition to the credit and operational risks associated with the mortgage portfolio.

In other words, mortgages are long term and the interest rate is a reflection of the risks of carrying this loan, including credit, operational and interest rate risks, over an average horizon of 15 years (average term of the mortgage book of the banks is generally 15 years). It is therefore inaccurate to compare the short term repo rate as a basis for the mortgage rate, as the two rates are in substance, fundamentally different.

Calculation of a

typical mortgage rate

For calculation purposes, one therefore needs to compare the cost of deposits over a 15 year period and the current mortgage rate. The banks would need to offer a rate of at least 6.50% for deposits over 15 years (using the recent Government of Trinidad & Tobago issuance of TTD 600 million offering at 6.50 percent -15 year tenor).

The table below illustrates the pricing of 15 year mortgages, which results in a mortgage rate of 8.00 percent as the best customer rate.

Current Mortgage

Rate Environment

The current mortgage rates offered by the banks are within 6.99 percent and 8.00 percent which is actually better than the ‘best customer rate.” It is equally important to note that mortgage rates have fallen from 10.00 percent in January 2009 to the present range stated above.

This represents a substantial savings to customers and is also a reflection of the general trend in rates i.e. repo and prime.

Some banks have already effected reductions in their mortgage rates, benefitting thousands of customers on their books.

Others are at varying stages in reviewing their present mortgage book and customers are expected to benefit from a discount on their existing rate.

The amendment to mortgage rates involves operational details in terms of identifying the various tiers of customers and comparing such against current rates.

Customer loan agreements also provide for prior notification when rate adjustments are to be made, hence the average mortgage book adjustment period is 90 days.

Market Outlook

Interest rate is a key monetary policy tool and a signal of economic activity and the health of an economy.

Globally, rates have been falling in an effort to stimulate economies and a similar policy stance has been taken in Trinidad and Tobago.

The current global financial crisis largely precipitated from low interest rates and irresponsible lending practices by financial institutions in major developed economies; leaving vital lessons for small developing economies like Trinidad and Tobago.

It would be irresponsible and reckless for the Central Bank and banking industry to adopt a policy of low rates in an effort to promote economic activity without the necessary checks and prudence required for maintaining economic and financial stability.

Major stakeholders i.e. shareholders, customers, depositors and the public at large, should mandate financial prudence from their banks. By the same measure, banks must ensure that their customers are provided with a comprehensive and sound package of services, without excessive risk and exposure, to ensure that we continue to weather the global financial fallout and strengthen our financial system.