NEW YORK — Responding to interest rate increases that have cut into their profit margins for the last six months, major banks across the country Wednesday raised their prime lending rate to 9.25% from 8.75% in the second such increase in just over a month.
The increase will produce higher costs for businesses that depend on bank loans for financing, as well as for millions of consumers whose automobile, home equity and credit card loans are pegged directly or indirectly to the prime rate.
Perhaps more important for the consumer, the increase reflects the upward direction of interest rates in general since early this year. Since the end of March, for example, the average rate on fixed-rate mortgages has risen to about 11.08% from 9.03%.
The bond market, like many economists, took Wednesday's increase in stride; many investors had expected a second prime-rate hike to follow closely after the last one, on Sept. 4, when banks lifted the key rate to 8.75% from 8.25%.
"Interest rates have been rising, if not in a spectacular fashion, then at least consistently," said Mark Obrinsky, chief economist for the U.S. League of Savings Institutions. "So it's not too surprising that we see a prime-rate increase."
The prime rate has risen 1.75 percentage points in five steps since bottoming out at 7.50% on Aug. 26, 1986. The new rate is the highest since March, 1986, when it dropped to 9% from 9.5%. The prime peaked in 1981 at 20.5%.
Wednesday's round of increases was set off by Chase Manhattan Bank and Citibank. They were followed throughout the day by most other top lending institutions, including Chemical Bank, Manufacturers Hanover Trust, Morgan Guaranty Trust, Mellon Bank, First National Bank of Chicago, Security Pacific National Bank and Bank of America.
Many economists predicted Wednesday that the banks would raise the key lending rate at least once more this year, and some said it could go as high as 10% by early next year.
In contrast to last month's increase, which occurred on the heels of the Federal Reserve Board's hike in the discount rate--the rate it charges on loans to financial institutions--to 6% from 5.5%, Wednesday's action was dictated by more general increases in bank expenses.
Interest Spread Narrowed
Banks customarily try to keep a spread of about 1.25 percentage points between the prime rate and their own average cost of funds. In recent weeks, that spread has narrowed to one-half point as rates have risen in the money market, where banks must go to borrow money themselves.
One factor behind Wednesday's increase in the prime rate, financial professionals said, is the increasing difficulty major banks have faced in attracting capital from overseas, where investors are concerned that the U.S. dollar's weakness will cut into their returns on dollar-denominated investments such as bank certificates of deposit.
In addition, domestic investors are concerned about the financial health of banks that have loans outstanding to Latin American or other less-developed countries.
Both concerns have forced the top U.S. banks to raise the rates they will pay on short-term "jumbo" CDs--those in denominations of $100,000 or more, a key source of deposits for the big banks. Rates on those CDs have risen nearly a full percentage point to more than 8.1% in the last several weeks--including a half-point rise since Sept. 29. The higher rates, in turn, produce pressure on the banks to get more in interest from loan customers by raising the prime rate.
Loan Reserves Increased
"For the money-center banks (the largest New York-based institutions), depositors want to be paid higher rates because of the foreign loan situation," said Allen Sinai, chief economist for the investment firm of Shearson Lehman Bros. Most major banks themselves validated those concerns earlier this year by sharply increasing their reserves for bad loans.
Sinai added that interest rates are rising in a predictable pattern for the current stage in the economy: Short-term rates--those to which the banks are most sensitive--are creeping up on long-term rates.
Economists said that the Federal Reserve Board has contributed to that trend, which tends to dampen inflation, by nudging up the so-called federal funds rate, which is the rate at which banks borrow excess cash from one another through the Federal Reserve. That rate was last quoted earlier this week at about 7.25%, up from 6.08% a year ago.
Although the Fed does not explicitly set the federal funds rate, it exerts a heavy influence on the federal funds market. As a result, changes in the rate are widely considered to reflect Fed policy.
The Fed has so far avoided a second increase in the discount rate this year, possibly because it is concerned about negative reaction in foreign currency markets. But some observers said that another hike could occur shortly after the Fed's Open Market Committee meets on Nov. 3. That might inspire yet another prime-rate increase.
Had Expected Increase
Many banking industry analysts said they had expected a prime-rate increase two weeks ago when the federal funds rate reached its present level. "But the big banks weren't certain about where the Fed funds rate would settle," said Harold Nathan, an economist for Wells Fargo Bank. "Today, Citibank and Chase apparently got concerned that the funds rate would stay where it is."
Although business loans have long been tied to the prime rate, only recently have the rates on consumer loans been closely associated with the prime.
"There was a time when the prime rate had relatively little impact on the average household," the Savings League's Obrinsky said. "But now, some auto loans, credit card rates and home equity loans are pegged to the prime." Generally, those rates are set at several percentage points over the prime.