The setting of an optimum base rate : building a theoretical rate

Abstract

With effect from 15 October 2008, the Governing Council of the European Central Bank (ECB) decided to lower its minimum bid rate by 50 basis points from 4.25% to 3.75%, in view of the then prevailing market conditions. A series of rate cuts in the minimum bid rate of the ECB followed this first decision, such that the minimum bid rate was reduced by 325 basis points to 1.00% in one and a half years. Initially domestic banks were implementing Governing Council decisions as soon as they occurred. However, following the rate cut taking effect on 11 March 2009, none of the domestic banks then operating in the Maltese Islands adopted this measure and no cuts were made to bank base rates. Such a decision was quite extraordinary for the local market since past movements in the base rate of domestic banks had always indicated that base rate modelling was mostly calculated on the ECB minimum bid rate. This study questions base rate modelling for domestic banks as it tries to identify the factors that influence base rate setting. Research was carried out on the type of market in which domestic banks operate. Both the data obtained from annual reports and financial statements, as well as figures for the number of licensed credit institutions (provided by the Malta Financial Services Authority), indicated that banks operating in the Maltese Islands were competing under an oligopolistic market structure. This dissertation also evaluated a historical analysis of the base rates set by four commercial banks; namely APS Bank Limited, Banif Bank (Malta) plc, Bank of Valletta plc, and HSBC Bank (Malta) plc. Deep analysis of the base rates discovered that the four banks under study have always competed in an oligopolistic market structure. In the past, three of the four banks under study modelled their base rate on variables related to liquidity. Today, banks operating in the Maltese market model their base rate as an average of liquidity variables (including the minimum bid rate, the gross domestic product, and the inflation rate), loan maturity, and the various risks that they face.