Why the Reserve Bank wants to ‘abolish’ the prime lending rate

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JIMMY MOYAHA: The South African Reserve Bank [Sarb] has put forward a proposal to essentially do away with the prime and repo rates as we currently know them. There is something known as a Sarb policy rate – which we traditionally know as the ‘repo rate’ – and we’ll be referring to the repo rate going forward.

But more than this, we’re going to ask questions around what this change means for lending in South Africa and for the interest rates that apply to the loans we take.

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No more ‘prime’ – Reserve Bank wants key rate to be used to price loans

I’m joined on the line by the head of market operations and analysis at the South African Reserve Bank, Bafundi Maronoti, to look at this and see what we make of it. Bafundi, lovely having you on the show, as always. Thanks so much for taking the time.

Give us a sense of the proposal from the Reserve Bank’s perspective and what it means in simple English for South Africans. Are we doing away with the referencing rates that we’ve known up to this point? What does this proposal mean?

BAFUNDI MARONOTI: Thanks for having me. Yes, you are correct. The proposal as it stands today is that we would like to abolish the ‘prime lending rate’ as a key reference that banks use to quote lending rates to their clients.

The way it works today is that when a client, just an ordinary person like you and me, goes to a bank for a mortgage loan or vehicle finance, a bank would look at the cost of its funding.

It then looks at what the credit risk profile is that attaches to me as a client or to you as a client. And then, depending on your risk appetite, it will determine the rate at which the bank would want to provide that loan to you.

Once that’s done, the expectation is then that rate is compared to what the prime rate is, expressed in prime-rate terms.

That’s how you get to a prime-plus, or prime-minus. What we are trying to do with this proposal is to say that banks should quote those rates with reference to the Sarb policy rate.

So if today a client has been priced or was given a loan at prime, essentially what happens here is where we want to go.

We want to get to a point where we would say that loan is provided at the Sarb policy rate plus 350 basis points, and we no longer have this concept of the prime lending rate in South Africa.

Because, as you would have picked up recently, it is quite confusing to many as it is understood to be the basis that banks use to negotiate loan pricing. But in fact that’s not what it’s meant to be.

JIMMY MOYAHA: Bafundi, from a banking perspective what does that then effectively change in terms of how banks operate? Does it change how the banks would then price consumers like you and me?

You touched on this saying that for the longest time we’ve had a misconception that the prime rate is the basis that the banks start at.

Therefore for many years we’ve inherently believed that the 300 basis points that sits between the two rates goes directly to the bank.

Does this proposal in any way adjust how the banks would then lend to consumers, or does it just simplify and provide a bit more transparency around how the banks arrive at their rate?

BAFUNDI MARONOTI: Our expectation is that if banks have been pricing loans the way they are supposed to, then there should be no change.

The only change that we would achieve here is greater transparency in terms of how lending rates look compared to the Sarb policy rate.

Because then essentially what will happen here is everyone will understand that the repo rate is set at 6.25% at the moment, but when I go to get a loan, my loan is priced at 10%.

That spread is therefore what you should understand as the additional premium that a bank is charging over the policy rate to its client.

Read: FSCA plans tighter rules for its sprawling repo market

But I think it’s also important that that should not be understood as a profit you imagine the bank is making, because it is also not necessarily the case that the cost of funding – or the interest that a bank pays to raise money elsewhere in order to provide you with that loan – is set at the policy rate. That’s not the case. It’s quite different.

So it should not make a difference in that sense except to provide clarity. I think very importantly there will also be clarity that, as and when the Monetary Policy Committee of the Sarb changes the repo rate or the Sarb policy rate – clients would then also see those changes in the interest that they pay on loans in pretty much the same way that there has been with the prime lending rate, because it would adjust by the same magnitude as the Sarb policy rate.

But what we do know is that that reference is made straight or directly to the Sarb policy rate as opposed to prime.

But in terms of how banks determine their lending rates, that should not change.

Our assumption is that banks have been following this typical way of pricing loans, which is to look at the cost of funding, look at the credit quality of the client that you’re providing that loan to, but also your own risk appetite as a commercial bank.

JIMMY MOYAHA: Bafundi, what would this mean for loans currently being priced at the prime rate, or at least linked to the prime rate? A lot of that is what is referenced from a financial standpoint, and I believe there are some 12 million contracts worth a little over R3 trillion in South Africa’s economy at the moment that are using the linked prime rate as a reference rate.

Does that then mean that from a repricing perspective or from a contract perspective, these contracts now need to be restated referencing the correct rates?

BAFUNDI MARONOTI: Not necessarily. What we’ve discussed and what we’ve articulated in this consultation paper of ours is that there are three considerations that need to be given when it comes to the transition itself.

The first is what we call ‘fallback language’. Fallback language essentially is that if the interest rate that is specified in your contract today ceases to exist in future, this is what you’re going to fall back on.

And so in this case that will say if banks continue to issue loans today that are referencing the prime rate, they need to embed fallback language in that contract that says ‘Should the prime rate cease to exist, we will use the Sarb policy rate as a reference’.

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That’s the first option.

The second option is that we would then encourage new contracts to basically just be referenced against the Sarb policy rate.

And then the bigger problem is the stock of legacy contracts that already have prime. As you say, our estimate at this point is about 12 million contracts to the value of R3.2 trillion.

Last, there’s what we call safe-harbour legislation. This is a process that we’re currently busy with, with the National Treasury, to develop that legislation that allows those contracts to remain as they are until they mature.

But there will be no confusion then in future when someone says ‘Yes, but my contract says prime – but prime is no longer there. So what does that mean?’.

We then rely on that paper legislation to deal with those problems because, as you can imagine, there might be someone today taking a 30-year mortgage who is referenced against the prime lending rate, and that contract is going to be there for the next 30 years.

Read: Time to take advantage of lower interest rates

So safe-harbour legislation then allows us to keep those contracts without necessarily having the headache of going through each one to change a reference rate that’s specified there.

JIMMY MOYAHA: Simplifying the lending rate in South Africa and making it much easier for consumers to understand how they are being financed – that is the latest proposal from the South African Reserve Bank, our central bank, to simplify the repo rate and prime lending rate.

We’ll leave the conversation on that note. Thanks so much to Bafundi Maronoti, the head of market operations and analysis at the South African Reserve Bank, who joined us to take a look at the bank’s latest proposal.

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