Base rates and bank interest rates

The Bank of England set the base rate. This is the rate at which they charge commercial banks to borrow from the Bank of England. In normal economic circumstances, this base rate will influence all the interest rates set by other banks and financial institutions.

  • If the Bank of England cut the base rate, you would expect banks to also cut their mortgage and lending rates.
  • If the Bank of England put up the base rate, you would expect banks to increase their mortgage rates.

uk-base-rate-v-bank-svr-500x336

The reason is that if commercial banks find it more expensive to borrow from the Bank of England, then they increase their lending costs to compensate. If it is cheaper to borrow from the Bank of England, they can reduce their mortgage rates and keep the same profit margin.

However, in the credit crunch, we see a greater divergence between base rates set by the Bank of England and actual bank rates that people in the real world face.

base-rates-bank-rates-mortgage-rates

interest rates at the Bank of England

This graph shows the gap between base rates and the bank rates

base-rates-bank-rates

After 2008, we see the gap between base rates and bank lending rates increases from 2% points to close to 4%. It means that mortgage holders haven’t benefited from the cut in base rates as much as you might expect.

Why gap between bank rates and base rates increased

In 2008, banks were short of liquidity, they wanted to increase their deposits and improve their balance sheets. Therefore, they were reluctant to lend and keen to attract savings. Therefore, they didn’t want to cut mortgage rates and lending rates. In effect, they were making it more profitable; they could borrow from the Bank of England at 0.5%, but they were lending out at 4%.

Interest rates are quantity of funds

Another issue is that the quantity of funds is important. After 2008, it become much difficult to get a loan. Even if interest rates were low, people couldn’t always raise a sufficient deposit to get a mortgage.

Credit policy

This suggests that traditional monetary policy (which focuses on Bank of England base rate) may be insufficient, and we need to have more focus on actual real life interest rates set by commercial banks. See: Credit policy with examples of interest rates in EU and Spain

Related

 

,

8 Responses to Base rates and bank interest rates

  1. Ralph Musgrave May 8, 2013 at 6:24 am #

    I love that last chart. It’s the final nail in the coffin of monetary policy, far as I’m concerned.

  2. yang May 11, 2013 at 3:33 am #

    It has highlighted how the wider economy is heavily dependent on the banking sector.

  3. Simon May 22, 2013 at 2:54 pm #

    Is this not evidence of Banks colluding to fix a market through anti competitive behaviour? Why are the banks not undercutting one another?

Trackbacks/Pingbacks

  1. Credit Policy - Economics Blog - May 8, 2013

    [...] See also bank and base rates in the UK [...]

  2. Over-financialisation of the economy - Economics Blog - May 10, 2013

    [...] The problem of the financial sector was that bank losses and the banks attitude to lending had a very significant cost to non-financial firms. Banking may only account for 8% of value added to the economy, but even now firms across Europe are experiencing high bank rates and difficulty in accessing credit. This credit crunch in the financial sector has harmed business activity. It has highlighted how the wider economy is heavily dependent on the banking sector. (see: bank rates vs base rates) [...]

  3. The great recession - Economics Blog - May 16, 2013

    [...] Commercial banks didn’t pass these interest rate cuts onto their consumers. Especially in the Eurozone periphery bank rates didn’t fall. In the UK, bank rates fell, but less than the cut in base rates. (bank and base rates) [...]

  4. Variable or fixed mortgage rate? - Economics Blog - May 22, 2013

    [...] In the past two years, I had a fixed rate mortgage rate of 4.5% (£680 a month) I though this was pretty poor given base rates were so low. It was a practical example of how bank lending rates were divorced from the Bank of England base rate. (bank rates vs base rates) [...]

  5. Housing Market Stats and Graphs - Economics Blog - June 14, 2013

    [...] There has been a dramatic fall in Bank of England base rates (which has continued to remain at 0.5%) but the bank’s standard variable rates have fallen at a much lower rate. See more at explaining the gap between base rates and commercial lending rates. [...]