Good time to review SA’s prime reference rate – economist

Now is a good time to review South Africa’s prime reference rate that has been in place since 2001, considering recent monetary policy changes, an economist says.

Although it will not, in itself, lead to lower interest rates, the South African Reserve Bank may use this opportunity to further strengthen the monetary transmission mechanism.

According to the Banking Association South Africa (Basa), banks offer each customer an interest rate for a loan that is quoted using prime as a reference rate on an individual basis. In line with monetary policy and inflation targeting, the South African Reserve Bank (Sarb) uses the repurchase (repo) rate to influence short-term interest rates in the market.

The Sarb uses this mechanism to control the cost of funding in the economy, which affects demand for goods and services and, in turn, inflation. The repo rate signals the direction and magnitude of changes in interest rates that the Sarb requires to give effect to monetary policy.

To ensure that there is an effective link between the repo rate and the prime rate for the transmission of monetary policy objectives, the Sarb fixed the spread between the repo rate and the prime rate in 2001.

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SA had 3.5% prime rate above repo rate since 2001

Jee-A van der Linde, senior economist at Oxford Economics Africa, says since 2001 South African banks maintained a reference rate, the prime rate, at 3.5 percentage points above the Sarb’s repo rate.

He points out that other countries, such as the US, follow a similar convention, while elsewhere policy-rate spreads reflect market-driven variability. After the recent change in South Africa’s inflation regime, the Sarb is reportedly reviewing the prime rate again, having concluded in 2009 that the existing spread has an immaterial impact on the pricing of domestic loans.

“Further noting that while adjustments to the prime rate may cause short-term disruption, the Sarb will not change the methodology for setting bank lending rates. Moreover, a uniform spread supports competition and allows customers to compare and negotiate rates based on individual credit profiles.”

Van der Linde says South Africa’s fixed repo/prime spread enables rapid monetary-policy transmission and supports standard, predictable pricing for borrowers and banks. He also points out that the Sarb’s monetary credibility is widely regarded as a key economic strength.

“Although interest rates have fallen by a cumulative 1.5 percentage points in the current cycle, monetary policy remains restrictive. Some argue that rates should decline more sharply and that a wide rate spread is not perceived as conducive to boosting private sector credit uptake.”

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Outsized spread could cause big banks to stifle competition

On the other hand, he says, an outsized spread may foster oligopolistic inertia among large banks, stifling competition and leaving consumers with rigid pricing that is unresponsive to periods of lower risk or changes in bank efficiency.

“Meanwhile, other noteworthy central bank benchmark reforms include the transition from Johannesburg Interbank Average Rate (Jibar) to the South African Rand Overnight Index Average (Zaronia), mirroring Libor reforms, aimed at addressing basis risk. This multi-year transition will see the cessation of the Jibar reference rate at the end of 2026. This transition has been clearly communicated to markets and may provide a valuable guide for potential changes to the prime rate.

“We view it positively that the authorities are continually reviewing the efficacy of industry reference rates and, in this instance, assessing the appropriateness of the prime rate and existing spread. This aligns with the central bank’s broader efforts to improve the banking sector, with the Sarb recently announcing a unified, white-label (machines owned and operated by non-bank entities) ATM network to cut costs, expand access and foster innovation, helping to ensure that changes in monetary policy reach the broader economy while boosting inclusion and efficiency.”

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Changing South Africa’s prime reference rate could cause short-term disruption

Van der Linde says changing South Africa’s prime reference rate could cause short-term disruption, but it will not, by itself, reduce borrowing costs or alter how banks set lending rates. “We believe the Sarb may use this opportunity to tighten the monetary-transmission mechanism by clearly communicating a reference rate that anchors expectations and ensures efficient policy pass-through.

“Early signs suggest the Sarb is making progress in its inflation transition, with inflation expectations edging lower toward the 3% target. A firmer rand, together with lower international oil and domestic maize prices, opens the door to additional rate cuts this year.

“While the uncertain external backdrop will keep members of the Monetary Policy Committee (MPC) cautious heading into the first policy meeting of the year, slated for January 29, we anticipate the Sarb will lower the repo rate by 25 basis points in at least one of its two meetings in the first quarter of the year.”

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Study showed role of prime reference rate and prime-repurchase rate

A 2010 study, The role of the prime rate and the prime-repurchase rate spread in the South African banking system, concluded that:

• A single policy rate does not impede competition among banks, but merely sets a benchmark in terms of the monetary stance of the central bank. It keeps the prime reference rate in line with the repo rate and removes the ability of commercial banks to deviate from central bank monetary policy objectives.
• The net interest margin, the difference between a bank’s average lending rates and its average cost of funding, is not the same as the difference between the repo rate and the prime rate. A fixed spread between the repo rate and the prime rate does not imply a fixed net interest margin for banks.
• A single reference rate – prime – makes it easier for customers to compare the pricing of various banks, relative to the same benchmark. A single prime rate and uniform spread, between the repo and prime rates, facilitates rather than prohibits competition.
• Banks determine their lending rates irrespective of the difference between the repo rate and the prime rate.

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Prevailing market conditions in 2001 made the choice for prime rate 3.5% on top of repo rate

The Banking Association South Africa says the difference between the repo and prime rates was 3.5% due to the prevailing market conditions and interest rate structures when it was fixed in 2001. Consequently, the spread of the prime rate over repo has remained stable at 3.5% since then.

The study concluded that there was no compelling reason to change the fixed spread of 3.5% between the repo and prime rates.

The Association points out that central banks often review policy and reference rates. “Basa and its member banks will participate in any review of the prime rate. Banks have already worked with Sarb on the review of the Jibar.”

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Changes in prime reference rate should not change cost of loans

Any changes to South Africa’s prime interest rate should not result in any changes to the cost of loans to bank customers. The interest rate charged to customers on loans is a result of various considerations, including:

• The cost of funds for that bank. Banks not only charge interest, but they also pay their depositors interest. A bank also borrows money from other institutions to whom they pay interest, and raises equity capital from shareholders to whom they pay dividends.
• The credit profile of the individual or company that is borrowing the funds. Banks will primarily look at whether the borrower has enough income to pay back the loan on the agreed terms and whether they have a good record of repaying their loans.
• The risk appetite of the bank, which is how much overall risk the bank is willing to take on. The risk appetite of individual banks varies, depending on their business model and their liquidity and interest rate risks.

The study also highlighted that the size of the spread between the repo rate and prime is immaterial to the setting of lending rates.

The Banking Association says in a statement that it is aware of reports that the Competition Commission is investigating alleged cartel behaviour related to the prime rate, but it cannot comment on the Commission’s investigation as it is not part of the proceedings.