THE SENSITIVITY OF THE PRIME RATE TO MONEY MARKET CONDITIONS

• Author: Michael A. Goldberg
• Published date: 01 December 1984
• Date: 01 December 1984
• DOI: http://doi.org/10.1111/j.1475-6803.1984.tb00379.x

The Journal of Financial Research • Vol. VII,

No.4.

Winter

1984

THE SENSITIVITY OF THE PRIME RATE TO MONEY MARKET

CONDITIONS

Michael

A.

Goldberg*

Abstract

Commercial banking's institutional setting can make one

bank's

profits dependent upon

the pricing strategies of its rivals. In this environment, widely disseminated prime rate quotes,

loan contracts with "most-favored-customer" clauses, and rule-of-thumb pricing techniques

can result in prime rate outcomes

that

jointly maximize

banks'

marketvalues. In this paperthe

relationship between the prime and money market rates is examined over the last decade to

determine if the prime rate behaves more like a competitive money market rate than an oli-

gopolistic price.

I. Introduction

Commercial banking is characterized by an institutional setting where one

bank's

profits may be a function of the pricing decisions of its rivals. Consequently, a

bank's

loan rate to its best business customers may be more like an oligopolistic

than

a per-

fectly competitive auction-type credit price. In this paper recent

bank

prime loan rate

charges are compared to auction-type money market rates of interest. The objectives

are (1) to determine whether the prime rate behaves more like a competitive money

market rate

than

an oligopolistic price

that

facilitates banks' joint utility-maximizing

behavior, (2) to ascertainwhether the adjustment of the prime rate to changes in money

market conditions varies over the business cycle,

and

(3) to examine if the relationship

between the prime

and

money market rates of interest has changed over time with the

development of the commercial paper

and

other direct credit markets as alternative

sources of short-term credit for

bank

customers.

II. Background

The prime rate is the business loan rate

that

banks have traditionally charged their

most creditworthy customers. Since nonprime customers typically have their loan

charges tied to the prime rate, the prime rate is a prominent barometerof credit market

conditions. Unlike auction markets where there are negligible transactions costs and

demand

and

supply are alwaysequal at the prevailing price, however, banks compete in

an institutional setting where loan prices are determined only after thorough credit

analysis

and

where the search costs to the borrower of soliciting alternative loan price

quotes may be substantial. This results in one

bank's

profits depending on the pricing

*Economist, Financial Studies Section, Board of Governors of the Federal Reserve System.

The

author

would like to

thank

Robert Avery, Terry Belten, the anonymous referees, and the editor for

helpful comments on an earlier draft,

and

Michelle Campbell and Bryan Davis for valuable research assis-

tance. The viewsexpressed herein are solely those of the

author

and do not necessarily reflect the opinions of

any member of the Board of Governors or its staff.

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