Interest rates: if money’s so cheap, why am I paying so much for it?

Bank of England Gold Vaults Gold bullion in the vaults at the Bank of England. Photo:NewsCast www.newscast.co.uk

The Matchstick Man is an economic illiterate who likes to ask awkward questions. This month: if interest rates are 0.5%, why the hell is my bank charging 18.9%?

My bank has just hiked the interest rate on my credit card to 18.9%. I’m nowhere near my limit and my circumstances haven’t changed. It’s just a “change of policy”, apparently. In the topsy-turvy world of finance, it seems if I want cheap money, I need a lot more money to begin with. Tossers.

After my rage subsided, this set me thinking about what we mean by “interest rates”. A Venusian perusing our press would think that interest rates are 0.5% in the UK and that they are set by the Bank of England. She reads on, and learns that rates have been at this “record-low” level for more than six years. But she’s confused: she can’t find a single Earthling who’s paying anything like 0.5% on their house, their car or their credit card.

Actually, the Bank of England doesn’t set interest rates, it only sets one interest rate. It’s called the Official Bank Rate (OBR) or the “base rate”, and it’s set by the Monetary Policy Committee (MPC), a group of seven men and two women who meet once a month, usually to decide to do nothing (I guess we’ve all been to meetings like that). Nevertheless, we all wait with bated breath for the committee’s decision and a there’s a whole industry of experts who try to read the signals buried in the MPC’s minutes for signs of when — if ever — rates might be changed. But the OBR has only a tenuous connection with what banks charge us for loans or pay us on our savings.

The OBR is the lowest rate at which the Bank of England will lend to other banks when they need cash in a hurry. This includes high street banks like Barclays and HSBC, as well as “merchant banks” — those exotic creatures that don’t have branches, like Merrill Lynch and Credit Suisse. As banks move money around a lot, they use this “lender of last resort” facility quite often — it doesn’t necessarily mean they’re in trouble. Unfortunately, neither you nor I can borrow from the Bank of England, however much trouble we’re in.

You can look up how much the banks have borrowed from the Bank of England each week. As of 17 September, it was £15,272,000,000 (that’s £15.3 billion, give or take a bit). That sounds a lot, but at the height of the banking crisis in January 2009 such lending reached £180bn. Banks borrow less from the Bank of England these days, not only because they’re more careful about who they lend to, but because their coffers are awash with cash from the “Quantitative Easing” programme (but that’s another story).

Making a killing

Banks borrow money from some people and lend it to others at higher rates of interest. That’s all they really do. So the rate at which they can borrow money is pretty crucial to how profitable they are. As well as the Bank of England, banks borrow from their customers – via our current accounts, savings accounts and other forms of investment – and from other banks. This “interbank” lending is very important, because you can’t rely on the likes of you and me coming up with huge amounts of money at a moment’s notice. The rate of interest on lending between banks in the UK is called LIBOR (it stands for “London Inter-Bank Offered Rate”). It was this rate that Barclays were caught fiddling a couple of years back. There are actually various LIBORs, depending on how long the bank wants to borrow for, and they are usually slightly higher than the OBR (e.g. at the time of writing, the 3-month LIBOR was 0.59%).

It’s obvious why banks like borrowing from us — they pay no interest at all on most current accounts and only derisory rates on the kind of instant access savings accounts most people have. But why borrow from other commercial banks if that nice Mr Carney charges less? The main reason is that the Bank of England demands security — in the form of shares, bonds, gold, foreign currency or anything else of measurable value – while other banks do not. This “no questions asked” borrowing is much easier to arrange. So, for the most part, banks borrow first from their customers, then from other banks and then from the Bank of England.

Borrowing money at 0.5% (or 0.59% ) and lending it out at 18.9% doesn’t seem like the most challenging way to make a living. Official interest rates may be at a record low, but rates for mortgages, loans and especially credit cards have not fallen anywhere near so quickly, or so far. According to the latest Bank of England figures, the average current mortgage rate offered is 4.5%, while the average on credit cards is 17.9%. The difference between official interest rates (what the banks pay) and the rates we get charged has widened since the 2008 crash (see chart below). Credit card rates have actually gone up. So are the banks just being greedy, or are there good reasons for charging us lots more for money than they have to pay for it?

Interest-rates-1997-2015

Risky business

The banks would say that one good reason is risk. As well as the cost of borrowing the money they lend to us, they have to price in the risk that we might not pay it back. This “risk premium” explains why riskier loans (for the banks), like credit cards, always have higher interest rates than safer bets like mortgages, where the bank can take your house if you don’t pay. Essentially, the banks are saying they’re always good for the money (so can borrow at 0.5%) but we might not be.

However, we now know that the banks aren’t always good for the money. Some, such as RBS and Lloyds TSB, effectively went bust in 2008 and had to be bailed out by taxpayers. Many others had to seek emergency help from the Bank of England. So we should perhaps see them as a very risky punt indeed. The ultra-low rates offered by the Bank of England cannot be a reflection of risk, otherwise the OBR would have shot up after the banking collapse, instead of falling rapidly to almost nothing. This seems to be a privilege extended to banks in recognition of their essential role in keeping the economy working. It’s not supposed to be a licence to (almost literally) print money.

And risk alone certainly can’t explain why the difference between OBR and rates on mortgages and credit cards has risen since the economic recovery began. The improving economy should mean fewer people are defaulting on their debts, so the risk premium should be falling and driving rates down. Instead, they’re going in the opposite direction.

One reason might be that the banks are a lot more choosy about who they lend to. It’s a lot harder to get a credit card with a whopping great credit limit than it was a few years ago. The days of the 120% mortgage are long gone. This is partly prudence on the banks’ part (they know they’re drinking in the last chance saloon), and partly due to government regulations which require banks to keep more of their assets in “reserve” – in cash, or things that can be quickly converted into cash, like shares and bonds – in case they get into trouble.

All this means fewer customers for loans. We should remember that despite the privileges they enjoy, and the responsibilities they carry, banks are conventional private businesses, whose only objective is to make as much profit as possible within the rules (and sometimes, as we’ve seen, outside them). Risky lending is highly profitable most of the time, which is why the banks did so much of it before 2008. So, to maintain their profit margins, they have to squeeze more profit out of fewer customers. This means keeping rates high, even for “safe” customers, and even when the cost of getting money has fallen to almost zero.

Competition or cartel?

This looks like profiteering. Why should the banks be able to maintain their profit margins when they were the cause of their own problems in the first place? Even I know that competition is supposed to stop this kind of thing happening. Because they can get money so cheaply, banks should be competing against each other to offer lower rates to customers. But with banks, competition doesn’t seem to work. Most continue to charge extortionate rates, with low rates available only to a few privileged customers (most of whom probably don’t need to borrow anyway). Such competition as there is generally revolves around gimmicks like free cinema tickets or temporary “zero” rates on balance transfers which expire into usury a few months later.

The banks seem to be functioning as what economists call a “cartel”. This is where, instead of competing to offer lower prices or higher quality, firms collude with each other to keep prices high. They don’t have to hold summit meetings, as the oil-producers’ cartel OPEC does; it’s enough that everyone knows on which side their bread is buttered.

How do they get away with it? I dimly remember from my O-level economics textbook that a competitive market can’t work effectively unless firms are relatively free to join or leave the industry. It’s very hard to set up a bank, as the Channel 4 TV series Bank of Dave demonstrated. This confines the banking market to a few well established players with the same attitudes and business models. When you do get new entrants, like Tesco Bank, they tend to be big firms who are used to playing by the same rules (the supermarkets looked a lot like a cartel, at least until upstarts like Lidl and Aldi came along). Combine this with government regulations which concentrate on protecting the banks from collapse rather than consumer welfare, and the conditions for a price-fixing cartel are ripe.

So, it seems the interest rates we actually pay are determined by the banks themselves and their need to deliver quick profits to their shareholders. The Bank of England’s official rate is only one influencing factor, along with LIBOR, assessments of risk and a host of other things. The obsessive attention paid to the “Official Bank Rate” has the look and feel of propaganda. Just like GDP, it’s a number we’re told is important, but which has little relevance to our lives. The more useful statistics are given much less publicity and tell a much less happy story about the way our economy works.