This Week In Finance

"What Has Happened to the Prime Rate?"

As a beginning economics student many years ago, I was perplexed by the professor's continual reference to "the market rate of interest." When I looked in The Wall Street Journal, I found several rates - rates on US Treasurys, corporates, agency issues, etc. "Which one of these is the market rate?" I finally asked. "They all are," he answered. "Next question?"

Well, I have been a keen follower of interest rates ever since, and thought adopters might be interested in an article in the September 28th issue of Barron's entitled "Ready for Prime Time?"

As all of you know, long-term Treasury rates have reached historic lows (as this is written, the rate on the bellwether 30-year "long bond" is just over 5 percent). However, while the prime rate has been declining fairly steadily for several months, the prime rate has been seemingly fixed at 8.5 percent. This seeming "disconnect" between the movement of the long Treasury rate and the prime rate provides a good opportunity to discuss (a) just what the prime rate is (and isn't), and (b) how institutional factors influence market rates.

First of all, just what is the prime rate? In "Wall Street Words," David Scott defines it as the "short-term interest rate quoted by a commercial bank as an indication of the rate being charged on loans to its best commercial customers. Even though banks frequently charge more and sometimes less than the quoted prime rate, it is a benchmark against which other rates are measured and often keyed."
Similarly, according to "The Illustrated Encyclopedia of the Securities Industry" by Allan Pessin, the prime rate is "a preferential rate and is supposed to be the lowest percentage at which [a] bank can realize a profit from borrowers." Further, he suggests that the prime rate "is generally about 1.5 percent above the average federal funds rate at major banks in large cities."

However, the Barron's piece illustrates how times have changed. A Wall Street research director states "[p]rime doesn't quite mean what it used to mean . . . [i]t's not a corporate lending rate anymore." (emphasis added)

So what is it? And why is it behaving so strangely?

According to the article, the meaning of the prime rate has changed over the last twenty years, as the debt markets evolved, and banks found themselves competing against commercial paper. As a result, lending rates for the largest creditworthy customers began to more closely reflect (rapidly-changing) short-term market rates.

On the other hand, the rates on loans to smaller commercial borrowers (who have lesser access to financial markets) as well as rates paid by consumers, have continued to be linked to prime. Thus, "the market rate" depends (of course) on which market you are participating in.

And why has the prime rate been so slow to move recently? (Or, as Barron's notes, why is the prime rate now "the only key rate that's over 7 percent?" The answer here is less clear. First, the prime-fed funds spread is not constant. Since the 1980s, it has fluctuated between 1 to 3 percentage points.

Second, by maintaining the level of the prime rate while the rates at which they can borrow have been falling, banks have increased their margins on consumer and small commercial loans. (As one economist notes, "Consumer loan rates are incredibly sticky. It's profit-maximizing on the part of the banks.")

Finally, given the consumer orientation, it is also suggested that the wide spread is necessary to compensate lenders for transactions costs and loss ratios on the bank cards they have mailed out in the millions over the last 10 years.

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