A few weeks ago the South African Reserve Bank, an institution long associated with the prudence and pragmatism that is aligned with its role as a custodian of a system that must be carefully managed, indicated that it was considering reforms to the prime interest rate.
This came shortly after a recent great shift that pitted policymakers against policy implementers, when the Bank expressed interest in narrowing the inflation range it uses in its decision-making. Changing the 3%-6% inflation range to a singular 3% target with a percentage point latitude in either direction represented a fundamental change to how South Africa’s monetary policy is managed.
As a critical input into monetary policy decisions, the inflation target has a material effect on all aspects of the national economic profile. The inflation range’s direct influence on interest rates transcends policy and politics. When the Bank first professed the desire for change the natural reaction was to question whether the Bank had the authority to take what is understood to be a policy decision, which should be the domain of policymakers.
Finance minister Enoch Godongwana had to state in August that the call was his to make and for the Bank to implement. While this reinforced where the line is between politicians and bureaucrats it ended up being a temporary standoff as barely weeks later the minister announced that the wishes of the Reserve Bank had prevailed anyway and the new target was adopted.
The recent conversation about the prime rate elicited excitement mainly because of longstanding misconceptions about what it all means. In banking lexicon the idea of prime interest rates has become socialised and understood by some to indicate the zone of creditworthiness we should all aim for.
The consequence of the change is simply that banks will end up with many more — if not all — clients being charged “cost-plus” rates and the linguistic semantics of “prime minus” — so long a nice selling point for banks — will yield to the reality that everyone pays the cost of funds plus something.
The reason for that is the prime rate is the one a bank should offer to its best clients, those who are not expected to default on their credit agreements. When such clients exist the assumption is that every bank will wish to attract them and hence the interest rate quoted to them will be the best one available.
That reality overlapped with the issue of where banks historically sourced their funding. When the banks sourced funds from the Bank priced at the repurchase rate the baseline cost (repo rate) was similar and the margin on those funds — which allowed banks to cover transaction costs and a profit margin — became entrenched at a rate of 350 basis points above the repurchase rate.
By calling this the prime rate the industry entrenched the idea that the best clients would be allocated this rate and we should therefore all aim for it. The reality, though, is that each bank’s lending decision should be unique, based on its cost of funding as a starting point. Once a bank factors in the unavoidable costs of making the credit agreement profitable, the rate quoted will inevitably be higher than the funding cost but need not be 350 basis points above the cost of funding.
Good clients will be closer to the funding costs and less creditworthy clients will be charged more. The consequence of the change is simply that banks will end up with many more — if not all — clients being charged “cost-plus” rates and the linguistic semantics of “prime minus” — so long a nice selling point for banks — will yield to the reality that everyone pays the cost of funds plus something.
Rather than altering the cost of credit, it is that “something” that will distinguish clients and form part of the new lexicon.
• Sithole is an accountant, academic and activist.
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