Will cutting rates be beneficial for the public?
As the credit crisis deepens and more people are feeling the real impact as credit becomes more difficult to obtain, the focus on interest rates has never been greater. 12 months ago, only those connected to the financial services industry were aware of LIBOR and its importance in the marketplace. Today LIBOR is discussed in living rooms and pubs throughout the country with many of these discussions fueled by news reports on television.
As a nation, we are now all aware that LIBOR, or the London Inter Bank Offered Rate, is the rate at which banks borrow from one another, and is therefore a benchmark for how the lending markets worldwide should react.
The British Banking Association (BBA) works out the BBA LIBOR rate on any given day by taking the inter bank borrowing rates from 16 contributor panel banks and analyses the middle eight rates (dismissing the first 4 and the last 4) to arrive at an average 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.
In clamoring for reductions to be passed on there are a number of factors that appear to have not been taken in to consideration;
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.
Banks who wish to lend to other banks at the LIBOR rate will be looking at the performance of the borrowing bank's mortgage book. This will inevitably have slipped with the decrease in rates, and will of course only slip further as more cuts happen in the future. As a result, banks will become more unwilling to lend out as the possible risk of lending increases, which will in turn be detrimental to the LIBOR rate.
There is another way that banks achieve funding for their daily dealings. Income from their loan books and retail deposits are also used for mortgages and loans. This is how some banks have been able to keep afloat during the recent crisis and it is indeed true to say that the competition that now exists for investments is every bit as intense as it was for mortgages just a few years back.
The drop in rates will mean that the income derived from borrowers will plummet, although banks will continue to grapple for investment business. Therefore the bank's profits will droop and their recovery will be made slower. As the banks fight for investment, the rates drop even below the LIBOR rate, meaning that the only way for banks to get liquid funds is through retail business. In that respect, LIBOR must then drop far enough to be attractive to banks in comparison with the cost of getting in retail business.
In conclusion it is fair to say that the Governments strategy has had a positive impact on the market and will provide much needed confidence. However it is also fair to stay that there are still many challenges ahead and the antidotal injection of cash and reduction of interest rates will certainly come with some painful side effects. On a side note while I write this, LIBOR has actually gone back up to 5.65% go figure!
As a nation, we are now all aware that LIBOR, or the London Inter Bank Offered Rate, is the rate at which banks borrow from one another, and is therefore a benchmark for how the lending markets worldwide should react.
The British Banking Association (BBA) works out the BBA LIBOR rate on any given day by taking the inter bank borrowing rates from 16 contributor panel banks and analyses the middle eight rates (dismissing the first 4 and the last 4) to arrive at an average 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.
In clamoring for reductions to be passed on there are a number of factors that appear to have not been taken in to consideration;
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.
Banks who wish to lend to other banks at the LIBOR rate will be looking at the performance of the borrowing bank's mortgage book. This will inevitably have slipped with the decrease in rates, and will of course only slip further as more cuts happen in the future. As a result, banks will become more unwilling to lend out as the possible risk of lending increases, which will in turn be detrimental to the LIBOR rate.
There is another way that banks achieve funding for their daily dealings. Income from their loan books and retail deposits are also used for mortgages and loans. This is how some banks have been able to keep afloat during the recent crisis and it is indeed true to say that the competition that now exists for investments is every bit as intense as it was for mortgages just a few years back.
The drop in rates will mean that the income derived from borrowers will plummet, although banks will continue to grapple for investment business. Therefore the bank's profits will droop and their recovery will be made slower. As the banks fight for investment, the rates drop even below the LIBOR rate, meaning that the only way for banks to get liquid funds is through retail business. In that respect, LIBOR must then drop far enough to be attractive to banks in comparison with the cost of getting in retail business.
In conclusion it is fair to say that the Governments strategy has had a positive impact on the market and will provide much needed confidence. However it is also fair to stay that there are still many challenges ahead and the antidotal injection of cash and reduction of interest rates will certainly come with some painful side effects. On a side note while I write this, LIBOR has actually gone back up to 5.65% go figure!
About the Author:
Mortgage Route gives assistance help and advice on mortgages from qualified mortgage brokers along with free mortgage calculators and sourcing tools.
posted by Credit Counseling at
2:49 AM
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