Will cutting rates be beneficial for the public?
The credit crunch is undeniably having a huge impact on peoples finances, and with credit being harder and harder to obtain, the general focus is now on interest rates and how they will affect the individual. LIBOR, once only heard of in financial circles, is now the hot topic of conversation across the nation, as media coverage speculates on the possible outcomes of financial aid packages.
The nation is now aware that LIBOR, the London Inter Bank Offered Rate reflects the actual rate at which banks borrow money from each other and is accepted as an accurate barometer of how global markets are reacting to market conditions.
The British Banking Association (BBA) takes the inter-bank borrowing rates from 16 contributor panel banks and looks at the middle eight of these rates (discarding the top and bottom four) and uses these to calculate an average, which then becomes that day's BBA LIBOR rate.
The gap between the LIBOR rate and the Bank of England base rate has for the past year, been large by historic standards and this gap has been more prolonged than ever before. The rate has reduced slightly over recent weeks culminating in the 1.065 percentage point reduction on Friday to 4.496 its lowest since April 2004 this after the Bank of England slashed interest rates by 1.5% to 3%. There has also been a great deal of pressure placed on banks from both the government and the media to pass on these rate cuts to customers. Many of the leading banks have now shown a commitment to following the Bank of England's lead.
But there would appear to be several things that have been overlooked in the rush to pass on the perceived benefits of the drop in the base rate.
Now, as I have said, the drop in the interest rate would seem to be welcome news for all concerned. But it pays to look at this from the banks point of view. If they pass on the rate drop and it applies to someone who is in payment arrears then this could be detrimental for both the customer and the bank. For example say you have a customer who has monthly payments of 350 and is in arrears of 300 would not necessarily be perceived as a risk. Now say the rate is passed on and his monthly payment drops to 280. This means that the customer is more than one month in arrears. This creates a domino effect because with each passing month the debt is not being cleared and more is being owed. It soon gets to the stage where this will be seen as a bad debt and put in the hands of solicitors for collection. Not a good position to be in.
You then have to take into account the effect it has on one banks willingness to lend to another bank. Due to the rate cuts there will most definitely be deterioration in the state of the borrowing banks mortgage book. This will in turn have an effect on the lending banks eagerness to loan out money and in turn have a negative effect on the LIBOR rate as it will rise to reflect the state of the market.
This is however not the only form of funding. Banks fund loans and mortgages from retail deposits and the income derived from their existing loan book. Those banks that have continued to trade in recent months have managed to do so essentially on the back of retail funding, and the drive for investment business has been as aggressive as it was for mortgage business in recent years.
The reduction in rates will result in banks receiving less income from existing borrowers, yet there is still the drive to compete for investment business. This will reduce profit margins and slow down the rate at which banks will recover. As banks compete for investment business, rates available are much lower than the LIBOR rate. This means that the banks strategies for obtaining liquid funds will remain firmly focused on retail business. LIBOR therefore has to fall to a level that is attractive to banks compared to the cost of attracting retail funds.
To summarise, there is little doubt that the government's actions have boosted confidence levels and created a positive impact on the money market. However there is still a long way to go, and many more challenges to overcome, and the cash injection and reduction in interest rates, although remedial, will still have a few nasty side effects. The irony is, as this article is written, LIBOR has gone back up to 5.65%, so who knows what to expect!
The nation is now aware that LIBOR, the London Inter Bank Offered Rate reflects the actual rate at which banks borrow money from each other and is accepted as an accurate barometer of how global markets are reacting to market conditions.
The British Banking Association (BBA) takes the inter-bank borrowing rates from 16 contributor panel banks and looks at the middle eight of these rates (discarding the top and bottom four) and uses these to calculate an average, which then becomes that day's BBA LIBOR rate.
The gap between the LIBOR rate and the Bank of England base rate has for the past year, been large by historic standards and this gap has been more prolonged than ever before. The rate has reduced slightly over recent weeks culminating in the 1.065 percentage point reduction on Friday to 4.496 its lowest since April 2004 this after the Bank of England slashed interest rates by 1.5% to 3%. There has also been a great deal of pressure placed on banks from both the government and the media to pass on these rate cuts to customers. Many of the leading banks have now shown a commitment to following the Bank of England's lead.
But there would appear to be several things that have been overlooked in the rush to pass on the perceived benefits of the drop in the base rate.
Now, as I have said, the drop in the interest rate would seem to be welcome news for all concerned. But it pays to look at this from the banks point of view. If they pass on the rate drop and it applies to someone who is in payment arrears then this could be detrimental for both the customer and the bank. For example say you have a customer who has monthly payments of 350 and is in arrears of 300 would not necessarily be perceived as a risk. Now say the rate is passed on and his monthly payment drops to 280. This means that the customer is more than one month in arrears. This creates a domino effect because with each passing month the debt is not being cleared and more is being owed. It soon gets to the stage where this will be seen as a bad debt and put in the hands of solicitors for collection. Not a good position to be in.
You then have to take into account the effect it has on one banks willingness to lend to another bank. Due to the rate cuts there will most definitely be deterioration in the state of the borrowing banks mortgage book. This will in turn have an effect on the lending banks eagerness to loan out money and in turn have a negative effect on the LIBOR rate as it will rise to reflect the state of the market.
This is however not the only form of funding. Banks fund loans and mortgages from retail deposits and the income derived from their existing loan book. Those banks that have continued to trade in recent months have managed to do so essentially on the back of retail funding, and the drive for investment business has been as aggressive as it was for mortgage business in recent years.
The reduction in rates will result in banks receiving less income from existing borrowers, yet there is still the drive to compete for investment business. This will reduce profit margins and slow down the rate at which banks will recover. As banks compete for investment business, rates available are much lower than the LIBOR rate. This means that the banks strategies for obtaining liquid funds will remain firmly focused on retail business. LIBOR therefore has to fall to a level that is attractive to banks compared to the cost of attracting retail funds.
To summarise, there is little doubt that the government's actions have boosted confidence levels and created a positive impact on the money market. However there is still a long way to go, and many more challenges to overcome, and the cash injection and reduction in interest rates, although remedial, will still have a few nasty side effects. The irony is, as this article is written, LIBOR has gone back up to 5.65%, so who knows what to expect!
About the Author:
Mortgage Route offers information help and mortgage advice from qualified mortgage brokers coupled with no obligation mortgage calculators and sourcing tools.
posted by Credit Counseling at
8:05 AM
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