Negotiation, Negotiation, Negotiation

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Bank Rates Cut, but don’t expect the savings to be passed on

Posted by markharrison on November 7, 2008

Yesterday, the Bank of England cut its base rate by 1.5%… taking it down from 4.5% to 3%. Today, the newspapers are full of stories about “greedy bankers” not passing on the rate cuts.

This makes good headlines, after all, we all understand that banks have a lot of money yes?

Well, no actually. The problem isn’t the rates – the problem is the fact that most banks DON’T have a lot of money – at least, they have a lot LESS money than people want to borrow.

The way that interest rates tend to work is as a sort of bidding mechanism. Suppose that we have three people:

  • Dave wants to borrow £100, and will pay 8% interest
  • Sharon wants to borrow £100, and will pay 7% interest
  • Steve wants to borrow £100, and will pay 6.5% interest

You have £100, that you’d like to lend out. Who will you lend it to?

Well, all other things being equal, I’m guessing that you’ll lend to Dave at 8%. OK, it’s more complex, because you’ll probably take into account Dave’s “track record” and other assets, but let’s assume that you know them all equally well, and take the view that each of them is as likely to pay you back as the other.

Now, the Bank of England cuts its rates by a third. Let’s re-run the question:

  • Dave wants to borrow £100, and will pay 8% interest
  • Sharon wants to borrow £100, and will pay 7% interest
  • Steve wants to borrow £100, and will pay 6.5% interest

You have £100, that you’d like to lend out. Who will you lend it to?

If you answered “Dave at 8%”, then you’re a greedy, bloated capitalist. After all, you SHOULD, according to newspaper logic, now be lending at 6.5%. Obviously, you now have a choice of people to lend to – and it really doesn’t matter which one you lend to, because you should be willing to accept the lower return?

Huh? How’s that meant to work then? Surely the idea is that you lend to the person who has the best mix of “rate (s)he’ll pay” and “likelihood of paying back”, depending on how risky you’re feeling, and what other loans you’ve got out there at the moment. You don’t just slash your rates.

The mechanism that ACTUALLY causes rates to be cut is COMPETITION. If you are only lending at 8%, and I come in, with £200, willing to lend at 7%, then you will either get no business at all (and therefore 0%), or you’ll have to drop to 7% to get someone’s business, and you and I will fight it out to make Dave and Sharon both think that we’re a good lender. Obviously, Steve still doesn’t get his loan… unless one of us decides that 6% is better than nothing, and drops the rates again.

The basic problem is twofold:

  • There’s still far more of an appetite for loans that there is cash in the lenders’ pockets
  • The Government are insisting that banks INCREASE the amount of cash they keep “in reserve” and DON’T lend out, so that they can avoid another Northern Rock.

Very few banks actually borrow from the Bank of England. It’s the Lender of last resort. Kick-starting the mortgage process again isn’t about reducing a “published” rate – it’s about making cash available, and the only real way to do THAT causes inflation, and headlines about the price of bread and fuel increasing. At the moment, inflation still looks a scarey risk.

My “out on a limb prediction”? Give it another year, and the Government will decide that enough is enough, and the pain of inflation is less bad than the paid of more business failures and redundancies – until then, expect headlines about greedy bankers but not real solutions.


8 Responses to “Bank Rates Cut, but don’t expect the savings to be passed on”

  1. Mark, Loved your explanations. Made complete sense, which is more than I can say for the economy at present! Unfortunately the situation get’s worse as the mortgage companies have now retracted most fixed rate mortgages and the self certs are upto 7.44% which is higher than the rental rate or bad creditors which sits at about 6.79% at present. The only hope I hold onto is that my mortgage comes to and end in Sept ’09 when the rates and banks should all be singing from the same hymme sheet at a rate of around 4.5/5%. Fingers crossed!


  2. britishpolitics said

    Great explanation. However, whilst the banks can close the doors to new business, there is ssome logic in them passing on rate cuts to existing mortgage holders. The inter-bank lending rate will come down, maybe not immediately, but it is not in the interests of the banks, let alone everyone else, if people default on their mortgages or loans. The problem is and banks will know this, if people can’t afford to pay their mortgage, they tend to stop paying altogether, rather than paying what they can afford. If banks pass on the rate reductions, then there should be fewer defaults.

    I don’t doubt your logic, explanation or prediction, but sometimes, there is a need for everyone, particularly banks and government, to look at the wider implication of their actions. Particularly when UK Plc has accepted so much risk, for the ‘greater good’.

  3. Britishpolitics,

    Your commend about banks helping customers in trouble is well taken, though there’s a good argument to say that they should allow “payment holidays” and the like to customers with real problems, rather than just cut rates left right and centre.

    On the UK plc accepting risk “for the greater good” – I have trouble with that. If you look at what Barclays has done in the last week, accepting an Emirates offer on WORSE terms than the one offered by the treasury, you’ll see that British banks are getting very scared of the treasury doing then any kind of “favour”. (The cynical might say that the Barclays thing was about stopping Darling interfering in senior staff salaries, rather than looking after shareholders, mind.)

    Make no mistake though, the “fat cat bank profits” actually, mostly, go to our pension funds… Not to the Directors of the high street banks. Giving a rate cut to mortgage holders takes profits away from UK people with private, or indeed, company, pensions.

  4. britishpolitics said

    I am not sure that a payment holiday is necessarily the best answer, but I have long argued in favour of a variation on the theme. When people start to struggle with their mortage payments, they often stop paying all together, because, for example, their DD was rejected. I believe a more responsible way for the banks to act during these times of hardship is to allow mortage holders to continue paying at the ‘old’ rate for a period and agreeing to add the difference onto the capital or extend the term. These has to be preferable to taking draconian repossession proceedings.

    I appreciate that many banks are ultimately, largely owned by pension funds, but my argument is not that banks should be deprived of their opportunity to make a profit, but that they should be pragmatic and also consider the costs of taking aggressive action against their defaulters. Equally, banks should remember, that people that pay their mortgages on time, every month are both customers and contributors to banking profits. They deserve loyalty and support in difficult times. In particular, I would argue, that the vast majority of those on the SVR, have been loyal, good customers, not tempted by short-term wins on fixed rate deals. I have been with my mortgage company for 15 years on an SVR and would count myself as a loyal customer, not a fair weather friend and therefore, I would expect to be offered a competitive rate of interest from my bank.

  5. Britishpolitics,

    I’m increasingly leaning to your point of view. I agree that loyalty cuts both ways, and that banks should do MORE to try to keep their current customers than they do to attract new ones (in good times and bad.)

    What concerns me is political interference in banking. I know it’s well-intentioned. I know that sometimes it seems to make sense… I’ve just seen it fail 10 times for every time it’s worked.

  6. Sabeen said

    Very realistic prediction. Similar blogs were written by many but all fell on deaf ears and now we are just waiting for some miracle to happen.

  7. Ed said

    Indeed, I quite frankly am not prepared to lend my cash to the banks at rates very much below 4-5% whatever the bank of England says. I will simply take out all my cash and stuff it under the mattress or buy gold, so it is completely counterproductive for the BoE to be slashing rates to zero – it destroys confidence, and if savers don’t lend money to the banks, the BoE will have to run the printing presses. Looks like we are in for a rocky ride.

  8. Thanks in support of sharing such a nice thought, piece of writing
    is fastidious, thats why i have read it completely

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