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July 10, 1981
Costs, Competition and the Prime
Regular readers of the financial press may
have noted a growing divergence in the way
the media treatthe news about changes in the
banks' prime business-loan rate. Most editors
still give the prime a prominent place on the
financial pages-"above the fold" -;-along
with news about the stock averages, the
money supply, and the price of gold. Others,
however, are beginning to question the
newsworthiness of the prime, arguing that it is
no longer a usefu I barometer of the price of
credit.
This questioning of the value of the prime
reflects the growing tendency by banks to
lend below the prime-in effect, discounting
that rate. This behavior appears to violate the
classic definition of the prime as the rate
available only to borrowers with the very best
credit credentials. Actual loan rates
supposedly are always scaled upward from
the prime, depending upon the risks of the
loan or creditworthiness of the borrower.
In the words of one somewhat jaded banker,
"Everybody worries about the prime rate, but
few people pay it." Or in the words of
another, paraphrasing Humpty Dumpty,
"The pri me rate means just what we want it to
mean." Despite all such disavowals, changes
in the prime are importantto financial-market
participants fortheir "announcementeffect."
The prime may not be an infallible guide to
the direction of interest rates, but it remains a
highly visible and reasonably representative
indicator of changes in the general cost of
bank borrowing. Consequently, we would
profit from a review of the cost and competitive factors that determine this key rate.
Nature of the prime
Many people mistakenly believe that the
Federal Reserve sets the banks' prime rate.
(Seeour Weekly Letter of February 20, 1981.)
Despite its strong impact on credit markets,
the Federal Reserve certainly does not have
"hands on" control of the prime. The Fed
influences the environment in which that key
rate is determined by controlling the rate of
growth of money and bank credit. If actual
money-supply growth diverges from the
Fed's money targets, market participants tend
to change their expectations regarding the
future course of money growth, inflation and
interest rates. Nonetheless, market forces of
supply and demand for credit accommodation remain the key determinants of the level
of money-market rates.
The prime rate itself, while quite sensitive to
changes in the money market, ,is not determined directly by market forces. Rather, it is
an administered rate-that is, determined by
individual banks. On occasion, major commercial banks have linked their prime rates
by formu la to some market rate, such as the
market for commercial paper or largedenomination certificates of deposit (CDs). A
typical formula might include a spread of
about 1Y2percentage points over the average
cost of commercial paper in the several
preceding weeks, which would mean a
pri me of 18112percent at the recent
commercial-paper rate of 17 percent.
This method of setting the prime has lost
popularity inthe last several years because of
the increased variability of market rates, and
the banks that used that approach have
reverted to setting the prime by administrative decision. Yet the prime is not immune
from the forces of the market, despite the
discretionary manner in which it is generally
set. Banks set the prime to equalize the
demand for credit with the supply of available funds, so that it represents the price
which banks perceive will clear the market.
Costs and competition
In their rate-setting decisions, bankers pay
close attention to the market quotes for large
certificates of deposit (CDs), which are an
important source of funds to banks when
managit:lg their liabilities and liquidity posi-
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Opinions
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in this nevvsletter do not
nece,>sarilv reflect the
of the manc,gemenl
of the Federa! Reserve Bank of San FrancIsco,
or or the Br)ard of Covernors
Reserve Svstem.
of thp Federal
"best" customers. It should be noted, however, that most banks have offered belowprime rates only on very short-term loans.
tions. CDs have gained in importance in
recent years, as banks suffered outflows of
"core" deposits-demand deposits and
low-cost savings accounts. But banks of
course can "manage" their CD liabilities by
their own rate decisions; for example, when
loan demand is slack and a bank has ample
fu nds, it can post a CD rate lower than the
prevailing market rate to indicate its lack of
interest in attracting more funds.
Recent rate trends
The prime rate has fluctuated substantially in
recent years, along with those rates that
bankers watch when setting the prime (see
chart). During the first half of 1 979, the prime
rate remained steady at 11% percent, while
the commercial-paper and CD rates ranged
around 10 percent or a little lower.
(Commercial-paper and CD rates generally
move closely together, because they
represent alternative short-term investments
to the average investor.) Market rates rose
sharply after mid-1 979, reflecting rising
inflation rates and investors' expectations of
worse to come. As those rates rose, banks
began to boost the prime, until it reached 20
percent in April 1 980.
Competitive factors, as well as costs, affect
banks' rate-setting decisions. Major corporations with the highest credit ratings don't
have to borrow from banks, but instead can
issue their own I OUs in the highly-organized
commercial-paper market. The commercialpaper rate currently is running about three
percentage points below the prevailing
prime. Not surprisingly, then, outstanding
nonfinancial commercial paper has doubled
since the end of 1 978, in contrast to a 12percent rise in domestic banks' outstanding
commercial loans over the same period.
The short but sharp business downturn in the
spring months reduced market rates by half
within a month's time. Tight credit controls,
plus recession-influenced rate expectations,
pushed market rates down during this period
-and pushed the prime down in their wake.
But rates recovered sharply with the secondhalf 1 980 business recovery -and they have
remained high (although sharply fluctuating)
so far this year because of a tighter monetary
policy, shifting credit demands, and a standoff between decelerating price indexes and
fears of a future resurgence of inflation.
Foreign banks also have come to playa major
role in this competition for corporate business, and now account for about one-sixth of
all business loans-considerably more in the
key New York and California markets. These
banks, despite growing restrictions on their
U.S. activities, can channel low-cost funds
from abroad to U.S. business borrowers. The
key rate in this competition is the LlBOR
(London Interbank Offer Rate), which has
been running at least three percentage points
below the prevailing prime. (LiBOR is not
clearly analogous to the prime rate because it
is generally quoted on a maturity basis; for
example, the one-to-six month cost of Eurodollar balances.) In any event, the availability
of low-cost commercial paper and foreign
loans has forced domestic banks to reduce
the price of credit to the very best of their
The prime rate, while not directly marketdetermined, certainly responds to the same
factors that act upon market rates. This helps
explain both the stratospheric level of the
quoted prime rate and the pressures forcing a
discounting of that rate. On the one hand,
banks now rely heavily upon deposits or
liabilities that they obtain in the money mar-
2
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ket, for whiCh they must pay the going market
rates. On the other hand, banks must respond
to the competition for business financing,
whether arising from the commercial-paper
market or from foreign sources.
regarding the trend of inflation and interest
rates. When market participants
a decline in the inflation rate, money-market
rates will begin to decline. Ahd since market
rates represent banks' marginal cosj of funds,
the prime rate at that point will also begin
to decline.
The prime rate thus has become more
responsive to market pressures over time,
such as market participants' expectations
Herbert Runyon
The Prime and the Market Cost of Funds
Percent
20
1 5·
Commercial
3-month Certificates
of Deposit
5
3
Paper
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BAN KING DATA-TWELF TH FEDERALRESERVE
DISTRICT
(Dollaramountsin millions)
Loans(gross,adjusted)
andinvestments*
Loans(gross,adjusted)-'- total#
Commercialandindustrial
Realestate
Loansto individuals
Securities
loans
U.s.Treasury
securities*
Othersecurities*
Demanddeposits- total#
Demanddeposits- adjusted
Savings
deposits- total
Timedeposits- total#
Individuals,part.& corp.
(Largenegotiable
CD's)
WeeklyAverages
of Daily Figures
Member BankReservePosition
Excess
Reserves
(+ )/Deficiency
(-) .
Borrowings
Netfreereserves
(+ )/Netborrowed(
-)
•
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OIVd
: J9VlS0d 's'n
11VWSSV1:>ISHI:I
SelectedAssetsand Liabilities
LargeCommercialBanks
• uo8aJO • ppPl\aN• o4PPI
P!UJOJ!lP:)
Amount
Outstanding
Change
from
6/24/81
150,268
128,549
38,398
52,713
23,008
1,644
6,340
15,379
39,730
28,035
29,878
81,156
72,223
32,029
6/17/81
631
750
477
84
50
52
85
34
-1,000
166
- 309
1,137
1,254
1,341
Changefrom
yearago
Dollar
Percent
13,273
13,068
4,924
5,907
870
699
12
197
1,613
- 2,480
2,149
17,525
17,428
9,352
Weekended
Weekended
6/24/81
6/17/81
n.a.
n.a.
389
135
n.a.
n.a.
9.7
11.3
14.7
12.6
3.6
74.0
0.2
1.3
- 3.9
- 8.1
7.8
27.5
31.8
41.2
Comparable
year-ago
period
55
1
56
* Excludes
tradingaccountsecurities.
# Includesitemsnotshownseparately.
Editorialcommentsmaybeaddressed
to
editor (WilliamBurke)or to the author.... Freecopiesof this
andother FederalReservepublicationscanbeobtainedby callingor writingthePublicInfonnationSection,
FederalReserveBankof SanFrancisco,P.O.Box 7702, SanFrancisco94120.Phone(415)544-2184.
PUOZPV
•
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@FedFRASER