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Thursday, November 27, 2008

Will cutting rates be beneficial for the public?

By Chris Clare

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.

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 rate is calculated by the British Banking Association (BBA) which takes the lending rate from 16 different contributing panels. They then disregard the top and bottom 4, concentrating on the middle average 8 rates. The average of these becomes that day's LIBOR rate.

Over the last twelve months the difference between the LIBOR rate and the Bank of England base rate has been substantial and it has also been acknowledged that the period of this variation is also longer than ever before. There has recently been a drop in the rate with a 1.065 percentage reduction on Friday 7th November giving a rate of 4.496% (its lowest point since April 2004), reflecting a slashing of the interest rate by 1.5% to 3% by the Bank of England. The pressure has been put on the financial institutions to pass this on to the general public, not only by the government, but also by the media. With this in mind, many of the leading banks are 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.

A reduction in interest rates to existing customers is very welcome. However from the bank's perspective this can have a detrimental effect on arrears performance. As borrower's payments are reduced this will automatically increase arrears percentages; for example a borrower who has a monthly payment of ?350 and is say ?300 in arrears, is currently 'off the radar'. However, should the monthly payment be reduced due to a rate cut to ?280 the borrower is now in excess of one month in arrear. This will be replicated throughout the collections process as those accounts that are one month move to two, two to three etc culminating in more accounts reaching the stage where they are referred to solicitors for litigation proceedings to commence.

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.

Banks will also face the situation where they will earn less money on their existing borrowers if the interest rate drops, but they will still have to aggressively seek new investment. Due to decreased profits the banks will take more time to recover from the crisis. If the LIBOR rate remains higher than the base rate then it will follow that the financial institutions main target for investment will focus on the retail sector. This creates a situation where only a substantial decrease in the LIBOR rate, that is to say in line with the base rate, will attract the banks away from the area of retail investment.

It has to be said that one good thing to come from the government proposals is that it has been a big confidence booster. But it is worth bearing mind that although the mood is slightly more upbeat of late, the drop in the interest rate and the injection of cash will also herald unforeseen problems as it aims to provide a solution to the problem. And, just to prove the point, as I write this the LIBOR rate has started to climb again.

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