Setting a Prime Rate Not as Simple as It Used to Be

Banks seldom explain why they do it when they do it, and they are reluctant to say how they do it. But raising and lowering the prime rate is one of the most widely publicized things they do.

Setting a prime lending rate isn’t as simple as it used to be, bankers and banking analysts say.

The main reason is that banks have been forced over the past decade to compete more vigorously than ever before for depositors and borrowers.

Deregulation of the interest rates that banks can pay on consumer deposits has made it more expensive for banks to attract funds.

‘Different Environment’

And when lending those funds, banks are finding they are no longer the primary source of money for some big borrowers.

“It’s a very different environment,� said Gerald Fischer, a professor of business administration at Temple University in Philadelphia. “There are a lot of other players in the markets.�

James Wooden, who follows the banking business for the investment firm of Merrill Lynch, Pierce, Fenner & Smith, added, “A lot has happened to commercial lending in the past few years, and it has been mostly negative for big banks.�

But not all bank watchers are sympathetic.

Robert K. Heady, publisher of the Bank Rate Monitor, a Miami-based newsletter that regularly surveys the interest rates banks are offering consumers, said rates that banks are paying for funds are falling faster than those they are charging for loans.

“The banks are not passing on the lower costs of renting their customers’ money,� he said.

The banks themselves seldom provide any explanation for changes in their prime rates, and are reticent about discussing publicly how they do it. “It is the rate we feel is appropriate,� one banker offered in explaining a recent rate adjustment. Even at that, he spoke only on condition he not be identified.

The American Bankers Assn. describes the prime rate as a benchmark “used to compute an appropriate rate of interest for a particular loan contract.� The rate that a customer must pay for a loan from a bank may be above or below the prime rate.

Among the things banks consider in setting the prime, the association said, are its cost of funds, its administrative costs and competition from other credit suppliers.

In setting a rate for a particular loan, the banks must consider the credit worthiness of the borrower, the nature of collateral the borrower may be prepared to put up for the loan, the length and size of the loan itself and the bank’s overall relation with the borrower.

Decisions on the prime rate are one of the most widely publicized things a bank does and, at most banks, the decisions are made at the highest levels.

The prime rate has inched down from a peak of 13%, which was in effect from late June through late September of 1984. It has fallen in amounts of one-quarter or one-half percentage point to about 11.25% at most of the major money-center banks.

The latest adjustments occurred in late November of 1984, a few days after the Federal Reserve Board reduced its discount rate to 8.5% from 9%.

But analysts and bankers say there is little correlation between banks’ prime rates and the discount rate, the interest the Fed charges on loans to member banks and other financial institutions. The Fed changed the discount rate not at all in 1983 and only twice in 1984, while banks shifted the prime rate 12 times.

Banks generally borrow sparingly from the central bank, treating it as a last resort when looking for funds. The Fed encourages that view.

On a day-to-day basis, banks get their funds elsewhere, and the rates they must pay to do so have the biggest impact on where prime rates are set.

Banks’ costs of funds vary from bank to bank and frequently depend on whether a particular bank gets its money chiefly from consumer deposits or from selling securities in the marketplace.

Wooden of Merrill Lynch estimated that some big New York banks get as much as 80% of their funds by selling securities on the open market and only 20% from consumer deposits. Small regional banks may get up to 80% from deposits and 20% in the open market, he said.

Over the past seven years, federal regulators have removed limits on the interest rates that banks may offer on consumer accounts.

One such account is the money-market account. The Bank Rate Monitor said its survey of 50 leading commercial banks, savings and loan assocations and savings banks showed the effective annual yield available on such accounts had fallen in 1984 to 9.01% in early December from 9.80% in mid-September. Only a few years ago, however, banks were limited by regulation to pay no more than 5.5% for consumer accounts.

Banks also get funds by selling securities such as certificates of deposit in denominations of $100,000 and more domestically and overseas. Rates on three-month certificates of deposit last year traded at 8.95% in early December, compared with 11.29% on average in September.

Banks also get funds by borrowing from other banks, paying an interest charge known as the federal funds rate. The fed funds rate has been trading slightly below 9% recently, down from 11.30% in September.

Cause of Drop?

But bankers say declining interest rates alone do not necessarily mean that banks’ costs of funds have declined significantly.

“It’s awfully hard to tell what banks’ cost of funds is doing,� said Temple’s Fischer, who wrote the 1982 book “The Prime: Myth and Reality.�

He noted that while the rates banks pay for money may fall, their costs decline only when they add to their borrowings.

Banks must also be sensitive to loan demand, and they have more competition as lenders.

Large corporations have increasingly lent money to each other in what is known as the commercial paper market. Fischer said the commercial paper market has grown to half the size of all outstanding commercial bank loans to business.

In addition, banks must set interest charges high enough to enable them to meet reserve requirements that commercial paper lenders do not have. “Banks are under enormous pressures to build capital,� Fischer said. “If they started dropping their lending rates too much, they would run into trouble.�

Richard Bove, who follows banking for the investment firm of Shearson Lehman/American Express, said banks are in some ways like steel or oil companies.