UK Bank rate hike could have limited impact on lending rates
Tuesday, December 21, 2010 at 11:21AM
Simon Ward

One of the many unfair criticisms of British banks is that they have failed to "pass on" official interest rate cuts, using wider margins to boost profits. Such claims are "supported" by reference to unusually-large spreads between lending rates and Bank rate – the average interest rate on the outstanding stock of bank and building society mortgages, for example, is currently 3.0 percentage points above the 0.5% Bank rate versus an average of 0.6 points over 2005-07, before the financial crisis.

Such statistics, however, are bogus because banks are unable to obtain marginal funding at Bank rate, or even at quoted short-term interbank rates in any size. A better guide to their cost of borrowing is the average interest rate on household time deposits – currently 2.6%. The spread of the average mortgage rate of 3.5% over the time deposit rate is 0.9 percentage points, below the 1.1 point average over 2005-07 – see chart.

Net interest income, in fact, suffers rather than benefits from low official rates, partly because banks are net lenders of funds at Bank rate as a result of QE – their cash reserves at the Bank of England now stand at £140 billion, or 3.7% of their sterling assets, versus about £20 billion before the crisis. The Bank, rather than commercial banks, is enjoying a major boost to its net income, with reserve liabilities earning Bank rate used to finance a gilt portfolio with an average running yield of about 4%.

The disconnect between Bank rate and banks' funding costs undermines another common claim – that lending rates would fully reflect any rise in official rates, resulting in a squeeze on borrowers' incomes that could abort the economic recovery. With the time deposit rate so far above Bank rate, it is much more likely that this spread – rather than lending rates – would take the strain in the initial stages of any policy tightening.

An increase in Bank rate, in other words, would help to bolster the Bank's inflation-fighting credentials and cap inflationary expectations without material damage to economic prospects.

Article originally appeared on Money Moves Markets (https://moneymovesmarkets.com/).
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