Who puts the 'prime' in US banking's prime lending rate?
When the prime rate moves, it ''appears a bunch of guys in a smoke-filled room got togther and decided what to do,'' says Alan Murray, vice-president of Citibank.
In fact, there is a logic to the way banks' prime, or benchmark, lending rate changes, Mr. Murray notes. The key force in causing changes ''is really the (banks') cost of funds,'' says Charles Steindel, an economist at First National Bank of Chicago. If these costs rise, so does the prime - eventually.
The latest hike in the prime came June 25 when First National Bank of Chicago raised the rate half a point to 13 percent. Other major banks quickly fell in line. This was the fourth hike in the prime since mid-March, when the base rate stood at 11 percent.
The boost came after the rate that banks have to pay on large three-month certificates of deposit (CDs) had risen from 11.25 percent late last month to 11 .80 percent on June 25. The large CDs are a major way banks raise the funds they lend.
Increases in the prime are important because they drive up the cost of borrowing, thus tending to retard business activity, economic growth, and job creation. And since some third-world nations' debts are tied to the prime, a hike in this rate makes it harder for debtor nations to repay outstanding loans, thus putting additional strains on the international financial system and US banks.
In the past, the prime was the lowest rate banks charged their most creditworthy customers. Loans to smaller or riskier firms carried a higher rate.
Now, ''the 'floor' effect of the prime has fallen away,'' says Bernard Markstein III, senior economist at Chase Econometrics, a forecasting firm. Big companies can go to financial markets and borrow just the way banks do. To prevent this kind of an end run by corporations, banks must offer large firms rates close to those offered in the money markets and below the prime. So the prime rate now is a benchmark rather than a floor.
Although the prime's function has changed, its political impact has not. So President Reagan was quick to say that ''there is no excuse for interest rates being at the level they are right now, other than fear of the future.''
''It is fear, but I am not sure how irrational it is,'' Chase's Mr. Markstein counters. As private borrowing collides with federal borrowing to cover the federal government's budget deficit, he expects the prime to climb to 13.5 percent by the end of 1984. Russell Sheldon, vice-president of Mellon Bank in Pittsburgh, sees the prime hitting 14 percent by December.
Chase expects the prime to peak at 16.5 in the April-June period next year.
''It is very rational to believe inflation rates will move higher as you move through a business expansion. It has happened in every other expansion,'' Mr. Sheldon says.
When inflation rates rise, interest rates tend to climb as well, as investors seek to have the return on their funds keep pace with rising prices.
Whatever their fears about rising inflation, banks boost the prime when their cost of funds rises. ''The key rate is the certificate-of-deposit rate. That represents a major price money-center banks must pay to obtain funds to relend, '' Mr. Murray says. Smaller banks outside the money centers of New York and Chicago raise more of their funds by taking relatively small deposits from individuals.
Once one bank boosts its prime, others are quick to follow because ''there is not a nickel's worth of difference between the (major) banks' cost of funds,'' Mellon Bank's Mr. Sheldon notes.
In a way, the matter of who boosts the prime first is a game of chicken, bankers say. Banks ''hold off on raising the prime until they have to,'' Mr. Markstein says. A premature move could cost the first bank customers if other banks did not boost their lending rates. Antitrust laws prevent banks from talking to each other about future increases in the prime.
While many loans are still tied to the prime, other benchmark rates increasingly are being used. One of the most common is the LIBOR, or London Interbank Offered Rate which tracks the cost of dollar deposits borrowed abroad. Often companies have the choice of a loan tied to the prime or to LIBOR. Since LIBOR changes daily, firms choose it when rates are coming down, but opt for the somewhat stickier prime rate when rates are rising.