Four major banks bet wrong on interest rates last week when they lowered their prime lending rates to 16 percent from 16 1/2 percent.
This week, those banks admitted that they had guessed wrong. Interest rates went up when the banks thought they were going to continue to go down. Because banks buy most of the money they loan out, the costs of making loans went up. On Tuesday, the banks boosted the key business lending rate back to 16 1/2 percent.
Most banks read the interest rate tea leaves differently than did Chase Manhattan, Morgan Guaranty, Bankers Trust and First Chicago (and other smaller institutions such as Washington's Riggs National). The bulk of the nation's banks didn't lower their base business lending rate from 16 1/2 percent. The banks that guessed wrong made less money on their business loans.
Chase, Morgan, Bankers and First Chicago saw a decline in interest rates and thought it would continue, said the chief funding officer of a bank that did not lower its prime. "There was an element of let's hope it continues and let's help it continue by lowering our prime rates," he said. "Our view was that maybe it was a little too soon."
Twenty years ago, the cost of funds to banks was stable. Most of the money they had to lend was in the form of checking and savings deposits--or "core deposits," as bankers call them. In those days, the prime rate changed infrequently.
Today, bankers buy most of the funds they lend and interest rates jump around. As a result, the prime (or base) rate can change often, depending upon changes in so-called open market interest rates. Among the key open market interest rates are those on federal funds (reserves banks lend to one another overnight) and certificates of deposit (deposits left with a bank for a specific period of time).
"There's nothing magical to setting a prime rate," said one major banker. "It's nothing more than a price. It's supposed to cover the cost of the funds you lend, your overhead and a little profit." Most of the expense the bank incurs is the cost of obtaining the funds that are then re-lent to customers.
"The base prime rate lags other interest rates," said Michael Callen, senior vice president of Citibank, New York's largest. "By the time banks move to change their prime rates the change in interest rates is behind us. Nevertheless, it's the base rate that gets the visibility."
The prime rate--sometimes called the base rate or the base lending charge--theoretically is the interest rate a bank charges its biggest and best corporate customers for loans of three months to a year. Increasingly, however, loans are being made to top-flight customers at rates usually below the prime rate. These big corporate borrowers have the muscle and prestige to issue their own IOUs (called commercial paper) directly to investors at a cost lower than the prime rate. Banks must lower their charges to keep the business.
While big companies often pay less than prime, smaller or riskier business borrowers traditionally pay a rate that is higher than the prime rate.
Analysts say that loans whose interest charges are tied to the prime lending rate probably account for no more than 40 percent of the loans made by the nation's banks.
Because the cost of buying funds is the biggest cost of making a loan, it is no surprise that during an era of volatile interest rates, prime rates will jump around frequently. It is also not surprising that different banks will interpret short-term changes in interest rates differently.
For example, Citibank's Callen said, during the week ended Feb. 3, three-month certificates of deposit (what banks must pay to obtain funds for three months) averaged 14.6 percent. A week later the rate averaged 15.32 percent and rose to 15.84 percent by the week ended Feb. 17.
Then short-term open market rates began to fall. By the last Wednesday in February, three-month certificates of deposit cost banks 14.57 percent, falling to 14.04 percent by March 3 and 13.77 percent by March 10.
But then rates reversed themselves. On Tuesday, the day the four major banks went back to a 16 1/2 percent prime rate, the interest on three-month certificates of deposit climbed above 14.5 percent.