R. W. Hafer

English

Research Papers in Economics

The Prime Rate and the Cost of Funds:
Is the Prime Too High?
R. W. HAFER
ANK lending rates recently have received con-
siderable attention in the popular press. There
appears to he widespread opisuion that the rates
charged hy banks exceed their cost of funds by an
abnormal atnount. The purpose of this article is to
assesswhether banks’ lending rates durisug the past few
months have been “too high” relative to other snarket
rates. Because the prisuue rate generally is viewed as a
benchmark lending rate forbanks, the analysisfocuses
on the recent behavior of this rate relative to other
market interest rates.
TIlE PRIME RATE AND THE COST OF
FUNDS
The prune rate quoted in thepress aisddiscussed by
the ptsblie comsusonly is considered to he the interest
rate charged to a hank’s most credit-worthy corporate
customers for short-term loans. The prime rate is not,
however, the rate charged toeach asidevery corporate
hormower; each bass amud prospective borrower have
theirown characteristics that may necessitate different
lending rates.2 For example, the loan rate chargedto a
specific etsstomer reflects that customer’s credit wor-
thiness, previous relationship with the bank, the ma-
turity ofthe loan, the nonfee services provided by the
bank in maintaining thebass, the use offixed or flexible
maturities and rates, and otiuer factors.
‘See, amusung othem-s, h’hobamt Rawami, “Reagan Says Lower Rates Up
to Bamuks, -- Wa.sltington Post, ~ 24, 1983; Teresa Carson,
“ReaganLatest to Criticize Bank Rates,“American Banker, Fehrmm-
ary 24, 1983; “More Pressmim-e on Luams Rates,” New York ‘Jimmies,
Feluruary 27, 1983; amid Leab R. Young. “Charges Agaimust Bamiks omi
Rates ‘Umufotmnded’,’ ,\‘ew York Janrnal i4’Coitmnmerce. March 18,
1983. For ams immterestissg consparisomu of today s argumemsts. see
Leossard Silk, “The Mystery of Highs Rates,’’ ,Vew York Times,
March 57, 1982.
2
Tlsefohbowimsg chiscussiomu draws ums Gerald C. Fisehuer. “Thse Myths
amid the Reality oftlse Prinse Rate,’’ Journal of Comntnercial Bank
Lending (Jmmh~’1982). pp. 1 6—26.
Before the 1970s, the prime rate was relatively slow
to adjust to market conditions. For instance, between
1929 and 1969, tlseprime rate cisanged only 40 times,
an average ofonceper year and less often than market
interest rates. In contrast, Since 1970 the rate has
changed amu average ofabout 13 times per year.
This shift in the prune rate’s more frequent adjust-
ment to credit market conditions occurred in 1972
whenthe FirstNational City BankofNewYork, kmuown
today as Citibank, announced that its prinue rate would
he pegged to the 90-day commercial paper rate. Tisis
change was important because it directly linked the
prime rate to current credit market conditions. Fur-
thermore, as the comnpetition for loanable funds and
the cost of liability management have increased witis
the advent of numerous finarseial innovations, banks
have become more sensitive to interest rate changes
when establishing their lending rates.3
The increased sensitivity oftheprune rateto market
rates has accompamuied certaiss changes in the credit
market. The m-apidly expasudisug use of tlue eosnsnercial
paper market as ass alternative to hank funding is one
example. Another is the incmeased competitiosu eomimsg
from money market fisnds which has increased the
need for flexibility in the isucome stream from tlse
hank’s loan portfoho. More recently. tlue volatility of
market rates luas contributed to snore frequesut changes
in the prime rate. Because of this sensitivity, tluere
should he a close empirical relationship between the
hank’s cost of funds and the primne rate. If suclu a
relationship exists, it can he used to assess the current
level of the prime rate with respect to other interest
rates that reflect the prevailing cost of funds facing
hamuks.
‘
5
lbid. See also, Michael A. Goldberg, “The Pricitsg oftlse Priune
Rate,” Journal of Baokfng and Finance (July 1982), sip. 277~96.
17FEDERAL RESERVE BANK OF ST. LOUIS MAY 1983
4
For examuphe, asof year-end 1981, ssegotiabheCDs at large weekhy
reportisug luanks witls assets of $750 mihhiosu or ssuore totaled
$137,490 milbidums - Consumer amsdh issdustriah loajss (C&l) were
$195,499 snilbioss. Thus, tbse ratio ofCDs to C&h loans was 0.7. us
Deeemsuber 1982, however, the ratio fell to 0.6 as muegotiable CDs
fell to $132,340 million, amsch C&1 loaiss issereased to $216,860
msuilhiosu.
5
Tlsis period is exanuined because it represents the data available
sisuce the advemut of msumnerous deregubatmomu measures. Omse smtebu
ehsamsge is the reserve requiressuemst for differeist huanks oms large
CDs. To ensure compatiluihmty, omihv the period simuce late 1980 is
usech. Its additioss. Goldberg hasexamimued tlue period fm-limit 1975 tdi
1980 aisd fomsnd simusihar results.
The primerate used is thse averageofdaily rates reported! by five
ofthue ssatioms’s tesu largest luamsks (huy sizeofdeposits, as dif December
31, 1980). The muuomuthuhy average imuchimdles all eahesudardlays; rates mor
weekemsds amid holidays are same as the pm’eeedimsg bsssiness day.
Thue CI) rate is the secomsdarv msuarket rate, muudimithuhy average of
daily rates, exehudissg weekends’,ssid holidays. l’bie daily rate is amu
average of the rates oft)~red by five or more dealers. The somsm’ee is
taluhe 1.35, in an)’ Federal Reserve Bnlietin,
The fedberah fmsnds rate sssed is a monthly average of daily rates;
the rate far weekends and holidays is the
1
ureeeding busimsess day’s
rate, l’he daily rate is detcrmnined by averaging the rates fromn
appm’oximssately six brokers ims the federal funds market reportimsg to
the New York Federal ReserveBank’s traditsg desk. ‘l’he imsdhividual
rates are “weighted” by thevohunue oftrasisactions amid, therefore,
amnommmut to the “effective” rate.
where PR5 represents the prinue rate, ~t_m stands for
eontemsuporaneous amid lagged values ofthe CD rate or
the federal funds rate, amid e~ is a random error terns.
The lags are included to reflect the pattern ohservecb ims
chart 1.6
Table I. reportsthe results fromn estimating equation
lover the period Septemnher J980to December 1982.
As Iuvpothesized, muuovenuents imu the primne rate are
explainedrehably by hoth the CD rate amid time federal
funds rate as proxies for the hank’s cost of loamuabie
funds.8 Each regression outcome suggests that the
prime rate reflects suotonly the marginal costofacquir-
ing additional fumuds (represented by the contempo-
raneous term), hut also the cost of managing existing
liabilities.°
Another interesting aspect oftheresults in table 1 is
the different hong-run effects. For example, a 100
basis-point change in the CD rate results in a 106
t’.A similar edmlsation is estimsuated its Gcshdl.serg, “The Prieimsg of tlse
Prime,” Imi that stud>’, however. only the CD rate is mmsedl.
‘The haglength was selected to muumnimize the standard error oftlse
ed5uatiosu. Ineach case, addisig anotbser lag cbmrh msot improve the fit
smgnmfieamsthy.
The Durhuin’\Vatsomu statistic fcsr the ecjuatioms usimsg tbse CI) rate
fulls ims the indeterminate rasuge. A
1
u
1
ulyimigafirst—order autocorreln’
tiosu eorm-ectioms prdieedure yielded an estimiuated valise of rbso that
was not statisticall>’ dhfierelst frosn zero at the 5 pem’eemst leveh.
Comusequemstly, thseOLS resultspresented in tahule I are mssed in tbse
amiahvsis.
8
An altersiative eqtmatidin was estimated usimugthe 4—mosstls eosssmer—
cial paper rate to exphaiss msuovemnc,tsts ims the prinse rate. Thsis rate
was used hecaimse it represesits ams alteniative soimree of fmsnds far
firmns and, therefore, a comiupetitive rate vis—a—vis the prinie rate.
The ommtedsme of tluc- estimation is
= 0982 SE = 03~4 DW 1.83 ~ = 0.33
where ~i sthe first-order serial eorrelatiotscoeffieie,st. The results
are quite similar to those presented in tabbe 1.
°Gokhberg.“The Pricing ofthePrime,” points out that this imsdieates
that banksengage its average—cost pricissg. hmu other words. “bamsks
pricetheir prime rate oms thebasis ofsomeaverage of their ctirremit—
ly —“ amid previously — issued, hunt still outstanding, costs of
managed hiahihities” (p. 292).
As noted by Goldberg, tlse estimnated cortstaist term’n (&,~)repre-
sents the huamuk’s profit margin. Note that the constant terns is
significamstly different fromzero for both ofthe equations reported
in table 1. hunt is not in the equation issing the commercial paper
rate (Fn. 7).
the prime rate level relative to other market m-ates. To
do this, the following equation was estimated:
N
(1) PRm = d1
0
+ ~ 13, 9_~+ Em.
i = 0
‘I’oinvestigate this issue, two interest rates are used.
One important source of boanahie fumids is the 90-day
certificate ofdeposit (CD) market; as suchu, tlue 90-day
CD rate is a useful measure of a bank’s cost of funds.
Although recent financial innovatiomss may luave less-
ened the once prinuary position held by tbue CD msuar-
ket, it remnaimus a key source ofhinds.4 Tbue federal fumucbs
rate — thue rate chuarged for ovem-mnght futuds — alsois a
useful measure of tlue hank’s cost offunds. It isot only
measures tlue bank’s cost of short-termn funds, hut also
is watched by credit market participamuts as a guide to
Federal Reserve actiomus. Its otherwords, it is viewed as
an indicator of whether cttrrent credit demnands are
beimsg mnatched by the reserves supplied to tbuehankimig
system.
The Ev”ide’n.ce
Chart 1 plots the pritne rate, the 90-day CD rate and
the federal fundsrate for the period September 1980 to
Deeeuuher 1982°As illustrated, time prime rate tends
to follow movemnents in the otluer interest rates, albeit
with a slight lag. This tendency reflects the previously
mnentioned sensitivity ofthe prime rateto othermarket
rates — that is, the effect ofcurrent and past costs of
the hatsk’s managed liabilities.
The datainchart 1 cams he translatedinto aregression
relationship to provide a more rigorous assessment of
PR, = 15-63 * 0.628 CPR
5
-5- 0.401
(109) (515+ (5.77)
CPR
1
_, ±0.184 CPR,_
2 (275)
18FEDERAL RESERVE BANK OF ST. LOUIS MAY 1983
Chart 1
The Prime CD Rate
and Federal Funds Rate
1978
Rate, 90-Day
Percent Percent
22 22
20
18
‘I
20
18
16
4
12
0
0
79
-Y
80 81
8
0
1982
19FEDERAL RESERVE BANK OF ST. LOUIS MAY 1983
‘
55
Coldlberg reluorts thuat, fmur the periodh Jannam’y 1975 to Octohuer
1980, the snmxssnedh elket ofehasiges iii the Cl) rate isis the pm’ime
rate is 1.076. For the period Jamsuary 1977 to October 1980, the
sum is 1.094. Thins. olmr resoltis comssistesst with tlsose from earbier
periods.
The smimmised efi)rct of the CD rate, however, is statistically
diffitresut fromss ussity (t = 2.31). Tlsis resultis expecterh given the
cost. over—amsdl—nbove imsterest, that tlse hunssk faces when it issmses a
new CI). Omse misajor cost isthe reserves that thie hank mssst hold
far each Cl) issue~h.Currently. the required reserve ratidi is 3
Iuereemst. If omse eahelmlates tlse ‘‘effective” cost of issmsissg a CD
oise thuat imscorporates both the imstem-est expemuseand the dipportuim—
itv cost ind’nrredby
1
su
1
r
1
i tsg msdu mi—itsterest—lueari mug resdtm’vd’s agairsst
the Ch) — a CI) ratetuf 10 percemut thems luecdimes 10.31 luereesst.
Thus, for a 100 basis—poimut change in tluc CD mate, the chaisge its
tbse effective cost tdi the bamuk aettsally is 103 luasis Iuoimuts. hmsdeedl,
the smmmmsued ehlect m’etuom’tedl imi table 1 dtues muot differ frons au
effective rate dif 1.03. TIuc hsvpditbicsis that ift = 1.03 camsisot be
rejecterh at amsy reasonable level of sigmiificausee (t = 1.22).
‘rIse effect of average-cdist pricing dnrimug pem’iods of risiusg asid
falhimug imstere,strates has beets muoteml isv Coldluem’g, ‘The Prieimsg of
The equations in table 1 were estimated through
December 1982 to permit out-of-sample forecasts of
the prime rate to he obtained fur the first four momuths
of 1983. If recent levels of the prime rate are sigmuifi-
cantly greater than those forecasted tmsing the regres-
the Prime, ‘ For example, bse states that ‘‘1)miring a period
1
of
declimsimsg itsterest rates ... their past—]sstmedl, but still dstitstatsdl—
ing, liahuihities are more expeussive than their emsrrentl—isslmed
msuamsaged liabilities. This leads to a sstmmatioms where their average
(over timsie) cost—baser! formula calls for a prime rate smsisstasutialhv
in excess of the batik’sprime emmstomners cost ofcommercial paper
fitsaiscimsg” (p. 288).
It also shotmld be smotedh that evsdhemsce exists suggesting that
huanks switels fromss avem-age’eost prscmg to marginal—edist pricing
disrimmg periodls of mlechsssnsg nsarket rates. In dither wdirds, hsamuks
mayprice dhiserimninate its favorof theirbest customers hiy differing
“below pt’imsic” hmsamus. hlecasise the sample nsedhhere is too restric-
tive to test tbi5
hvpdithscsis (the availahile dhata is dfliarterly), the
reader is refem’red to Coldhtuerg (pp. 289—92)for a discmussioms difand
empirical results favdirimug tlse “below prune” leisdiisg scenario.
Table 1
Regression Estimates of the Prime Rate: September 1980 to
December 1982
Summary
Es mated coefficients stat sties
Rate 0 R2ISE OW
CD 68 0664 0338 0164 1064 0983 145
(394 (163) (462) 337) (383 ) 0360
80 0.542 0.181 0243 0968 0970 73
(5 ) (680) (139 (304) (2735) 487
~tft ~ yOU ndFFi the edeattunderate
ste appear 05 parentheses
istheaditsi flint of erminatto tsthe ew Sin standardant rmdDwmsthe
Durbb-jNatsen S
basis point cluauuge imu the prime afterthree montlus. A
similam change in the federal funds rate produces a 97 able
basis-point change us the prime a change that is muot Actual andPorecasted Value of the
significantly diffement fromn 100 basis ponuts Note
howover, that these chunges occur over a three-month ~ RaLç, January 1983 to April 1983
horuzoms: about 55 percent of the eff et on the prime Fomc~ed ahhss using
rate occimrs simultaneously withchanges in the CD and Mli~ OP -- FE -~
fedcral hinds rates.
January1983 1 9 ‘tO-Vt 138~
This evid nec suggests that the prime mate closely F ~o9~ ~o~s ii I
reflects the costs faced bs banks in acquiring new and Maith 10.50 1072 1 0
in managing existing loanabie funds. Moreover the 1050 ton ti.77
fulleffect ofa change in the cost offunds on theprime
rate ss not immediate but takes phact over set ~ra1
months. Conseqis ntbt, reductions in the CD and the
federah hinds rates are unlikeh to psoduce imnuediate
declines ofequal magnitude in the pmime rate they will
do so only with a bag ofabout three months, ~
20FEDERAL RESERVE BANK OF ST. LOUIS MAY1983
sions reported in table 1, then recent criticisms may be
justified. Ifnot, then tlue recent heluavior of the prime
rate simply reflects the underlying relationship be-
tween a hank’s cost of funds and its lending rate cap-
tured in equation 1.
The prime rate forecasts based on the equations in
table 1 and the actual prime rate for January through
April 1983 are shown in table 2. During January, the
actualprune rate exceeded the rate forecasted withthe
CI) rate by about 50 basis points. In contrast, the
prime rate was 20 basis points iess than the one fore-
casted using tlue federal funds rate. Imu eaclu instance,
however, the forecast errors were not unusually large
for the estiniated equatioms; they were withintwo stan-
dard errors of the regression standard errors.
The lagged effectofthe recesutchanges in the cost of
funds (see chart 1) on the prime become more apparent
in February, March and April. During February, (hr
example, the average forecast error falls to 26 basis
points. By March and April, however, the predicted
prime rate exceeds tlue actual rate by an average of46
basis points and 77 basis points, respectively’. Civeuu
recent movements in the cost offunds, the results us
table 2 indicate that the prime rate has riot been too
high relative to other market rates during the past few
tnomsths.
CONCLUSION
Have bauuks kept the prime rate too high?” The
evidence presented in this article suggests that, rela-
tive to their cost of funds, banks have not kept the
primne rate unduly high during the past few muuomuths.
The prisuue rate adjusts, with a lag, to changes in the
cost of acquiring and managing loanable hinds. These
costs are represented here by the 90-day CD rate amsd
the federal funds rate. The well-established empirical
relationship betweemu the prime rate and these mea-
sures explainswhy the prime rate has not decreased as
fast as these other rates during early 1983.
21

The prime rate and the cost of funds: is the prime too high?

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The prime rate and the cost of funds: is the prime too high?

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