Defined Terms and Documents    

Extracts from -

*        Reserve Bank Research Discussion Paper dated June 1992; and  

*        'Background information re the increasing interest rate spread for Credit Cards'

LOAN RATE STICKINESS: THEORY AND EVIDENCE  -  RBA 1992 (by Philip Lowe and Thomas Rohling) noted that the Reserve Bank regulated lending interest rates until 1985 and post-deregulation lending interest rates, in particular Credit Card interest rates, did not fall in line with the Overnight Cash Rate, and when falls were passed on, it wasn't done quickly or completely, whereas when the Overnight Cash Rate increased, these increases were passed on by way of higher lending interest rate and more quickly.  Hence, credit cards interest rates were particularly sticky when the Overnight Cash Rate fell, as Credit Card interest rates regularly remained 'stuck'.

Background information re the increasing interest rate spread for Credit Cards

In April 1985 the 18% cap on Credit Card interest rates was removed by the RBA (bottom of page 7 therein).  Chapter 5 evidences that in 1985 the spread between the wholesale cost of funds and the maximum Credit Card interest rate was less than 1%.  That spread is now as high as 26.49% to the material detriment of Financially Uneducated And Vulnerable Australians that Lack Financial Acumen often due to poor Financial Literacy Capacity identified by the Reserve Bank as Persistent Revolvers.

The spread between the current Overnight Cash Rate of 0.25% and the Credit Card  Purchase Interest Rate of 20% is 19.25% circa. 

Presently the highest Purchase interest rate is 25.9% from "Lombard 55 Visa Card" and the highest Cash Advance interest rate is 29.49% from Latitude Financial's "Go MasterCard". 

That is a spread of -

*        22.4% between where Lombard borrows money from say one of the Four Pillars at approx 1% above the Overnight Cash Rate and what Lombard is charging its Credit Cardholders that make a Purchase using a Lombard 55 card; and

*        26.49% between where Latitude Financial borrows money from say one of the Four Pillars at approx 1.5% above the Overnight Cash Rate and what Latitude Financial is charging its "Go Mastercard" Credit Cardholders that take out a Cash Advance/s, ostensibly Financially Uneducated And Vulnerable Australians that Lack Financial Acumen due to poor Financial Literacy Capacity generally through no fault of their own.

ABSTRACT

Financial deregulation in the 1980s saw the lifting of regulations on interest rates charged by banks. In general, lending rates now respond more quickly to changes in banks' cost of funds than they did in the regulated period. However, lending rates still do not always move one for one with changes in banks' marginal cost of raising funds. This paper canvasses four theoretical explanations, other than collusive behaviour, for loan rate stickiness. These theories are based on -
(i)      equilibrium credit rationing,
(ii)     switching costs,
(iii)    implicit risk sharing and
(iv)    consumer irrationality.

Using regression analysis, we also examine the degree of stickiness of Australian interest rates on secured and unsecured personal loans, credit cards, small and large business overdrafts, and housing loans. We find significant differences in the degree of interest rate stickiness among the different rates, even after allowing for lags in adjustment. The rate on credit cards is found to be the most sticky, followed by personal loan rates, the housing loan rate and the small business overdraft rate. The large business overdraft rate is found to adjust one for one with banks' marginal cost of funds. We briefly examine the behaviour of selected U.S., U.K. and Canadian interest rates. The general order and magnitude of interest rate stickiness is similar to that found for Australia. Although it is not possible to empirically discriminate between the different theories of loan rate stickiness, we interpret the results as providing strong evidence for the switching cost explanation. In addition, implicit risk sharing probably plays an important role in the stickiness of the housing loan rate.

        1. INTRODUCTION

        In contrast to the bulk of studies on interest rate stickiness, we examine the behaviour of a number of different Australian lending rates. These include the rates on housing loans, secured and unsecured personal loans, business loans and credit cards.         

3. TESTS OF LOAN RATE STICKINESS

The empirical literature on price stickiness in banking has typically focused on a single deposit or lending rate. Yet, casual observation suggests considerable variation in the degree of interest rate stickiness across different products. The interest rate charged on credit cards remains constant for long periods of time while the rate charged on overdrafts changes regularly. In this section we formally examine interest rates on a number of different types of bank loans and, by examining differences in the degree of loan rate stickiness, draw some tentative inferences concerning the cause of the stickiness.

3.1 Data and Estimation Procedure

"In the case of overdrafts the maximum rate on all overdrafts was set by the Reserve Bank prior to February 1972". At that time interest rates on overdrafts drawn on limits over $50,000 became a matter for negotiation between the banks and their customers while those drawn under limits less than $50,000 remained regulated.  In February 1976 the threshold level was increased to $100,000 and in April 1985 all regulations were lifted.

From 1966, when personal loans were introduced, the maximum rate that banks could charge was set by the Reserve Bank. Once again, in April 1985, the controls were removed. At the same time, the maximum interest rate that could be charged on credit cards was deregulated. Prior to this time the maximum rate had been set at 18 per cent per annum.

The period of housing loan rate regulation extended beyond that for the other lending rates. Until 1973, the maximum rate that could be charged on housing loans was the same as that on overdrafts although banks typically charged a lower rate. In October 1973 banks agreed to a "consultative maximum" on housing loans which was below the overdraft rate. This was formalised in December 1980 when the maximum rate that could be charged on owner-occupied housing was set one percent below the maximum overdraft rate.  The ceiling on new owner-occupied housing loans was finally removed in April 1986.

TABLE 2 : TEST OF EQUALITY OF COEFFICIENTS: POST DEREGULATION

For the housing, credit cards and personal loan rates, the ranking in terms of the degree of stickiness is maintained. Even after nine lags are included the sum of the coefficients on all three of these rates remain significantly less than one. The same is true for the standard overdraft rate.

TABLE 3: TEST OF LAG SIGNIFICANCE: POST DEREGULATION

In contrast, the rates on personal loans and credit cards do not appear to be more flexible in the deregulated period.

4. SUMMARY AND CONCLUSIONS

This paper examines the degree of price stickiness in the market for bank loans. In the classical world of perfect competition, changes in marpal costs are translated into similar changes in the price of the product. We find that complete pass-through of changes in banks' marginal cost of funds only occurs with the base or reference overdraft rates to large and small business borrowers. For credit cards, personal loans, owner-occupied housing loans and the standard overdraft rate, changes in the banks' marginal cost of funds have not been translated one for one into the contemporaneous lending rates.