21 February 2020

At any rate, will the new loan prime rate matter?

The People’s Bank of China has placed high hopes on its newly introduced loan prime rate (LPR) mechanism which is seen as an important step in the reform of the nation’s interest rate toward a more market-oriented regime.

But will it become a popular pricing reference for mainland lenders?

Under the new arrangement, a total of nine commercial banks will submit their LPR, or loan rate to their best customers, and the central bank will calculate the weighted average of the rates after taking out the highest and lowest.

Many industry practitioners believe the LPR will provide an important guidance for banks as it will give them a clear idea of the market level. This will dissuade them from indulging in excessive price competition or exploiting the rate-setting freedom after authorities removed the lower limit on borrowing costs in July.

The LPR is also believed to be the central bank’s first major step in shifting the role of setting interest rates to the market.

To ensure the LPR’s validity, which justifies its status as a benchmark, LPR quotation members will be evaluated annually and the worst performers will be ousted and replaced with other lenders.

Using LPR as the starting point, banks can adjust the rate by factoring in the credit standing of the customers, the lender’s own cost of capital and operating expenses.

But in the United States, interbank rates serve as the most common loan pricing benchmark. 

Lu Zhengwei {魯政委}, chief economist at Industrial Bank Co. Ltd. (601166.CN), wrote in the Securities Daily on Tuesday that the prime rate is not considered a major benchmark in the United States as it accounts for only about 22.4 percent of the total loans.

Instead, banks look to the US dollar London Interbank Offered Rate (LIBOR) as the universal benchmark rate for the US market. Why? Because the interbank rate could be seen as the floor of market interest rate while the prime rate can be freely set by individual banks, therefore lacking in significance.

In England and continental Europe, the LIBOR and Euro Interbank Offered Rate (EURIBOR) are the benchmark rates. Other rates including the personal loan rate and credit card rate are calculated and adjusted based on these benchmark rates.

China may be a different case. Before Shanghai Interbank Offered Rate (SHIBOR) becomes a mature market, LPR has a complementary role to play.

SHIBOR does appear to be more market-oriented as it draws on 18 banks’ quotes, compared with only nine for the LPR.

That being the case, there are a few problems with the SHIBOR market at the moment. For example, three-month SHIBOR is the most active contract while trading volumes in other maturities like the six-month and 12-month SHIBOR contracts are light. This makes it difficult for the market to take the mid-term and long-term SHIBOR as reliable benchmark rates.

It is also not a bad idea to have more than one benchmark rate. The LIBOR scandal which broke out just last year, in which several US and European banks profited by artificially inflating or deflating their rates, shows that interbank rates can be manipulated and may not be a very accurate benchmark.

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EJ Insight writer