I predicted it before it even happened!

I knew that the US Federal Reserve Open Market Committee, under its newly appointed Chairman Mr. Ben Bernake was meeting on June 28 to 29th, 2006. As was anticipated, the Federal Reserve ("Fed") raised its federal funds rate, the interest rate that member banks charge each other, by a quarter-point to 5.25%, itself, the highest level in more than five [5] years.

I just opened some new mail, and in it was a letter from my lending bankers advising that effective the same date, the CI Prime Rate was being increased to 8.25% from their previous level of 8 percent. What was a cause of concern was that the letter gave as its basis, and I quote "due to a recent interest rate increase, the CI Prime rate is being increased to 8.25 from 8 percent."

The question that naturally follows then must be; and I ask it now: - "Who increased the interest rates and why"?

While I may be incorrect, the best I can surmise as an answer might be the US Federal Reserve itself. But why should US monetary policy have such an immediate impact on us here in Grand Cayman?

While I will not take the reader on a long road in this article, I feel that a little background education on who and what the Federal Reserve is might serve to enlighten all and in the end provide some additional insights as to the questions I posed above.

As mentioned above on Thursday, June 29th, 2006 the Federal Reserve Open Market Committee met, and for the 17th consecutive time raised its key inflation fighter- its Fed funds rate. And, they signaled that further rate hikes may still be needed to further fight US inflation. I would mention here that the latest US economic indicators reflect that the US economy barreled ahead at a whopping 5.3% pace in the first quarter of 2006. Leading economic forecasters now see the US economy growing 3.4% in 2006 (year-over-year basis).

The Federal Reserve is the central banking system of the United States. It was created by Congress via the Federal Reserve Act of 1913.

It has many important roles and responsibilities, but some of its main tasks are to:-

- Supervise and regulate banks 

- Implement monetary policy by open market operations, setting the discount rate, and setting the reserve ratio 

- Maintain a strong payments system 

- Control the amount of currency that is made and destroyed on a day to day basis (in conjunction with the Mint and Bureau of Engraving and Printing)

Other tasks include:

- Economic research 

- Economic education 

- Community outreach

The US Federal Reserve controls the size of the money supply by conducting open market operations, in which the Federal Reserve engages in the lending or purchasing of specific types of securities with authorized participants, known as the Fed's primary dealers. It also implements monetary policy by buying and selling federal government securities and by doing so, injects liquidity into the market or tightens money supply respectively.

By far, the greatest tool at its disposal in terms of implementing monetary policy is by targeting the federal funds rate. This is the rate that member banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed.

The Federal Reserve System also directly sets the discount rate, which is the interest rate that banks pay the Fed to borrow directly from it. However, a bank will prefer to borrow Fed funds from another bank, rather than from the Fed at the normally higher discount rate, which might suggest problems with the bank's credit-worthiness or solvency.

Both of these rates influence the prime rate which is usually about 3 percentage points higher than the federal funds rate. The prime rate is the rate that most banks price their loans at for their best customers.

So, there you have it! The US Federal funds rate and its discount rates are tools that are employed by the US central bank to control inflationary concerns and by extension the banks increase their prime lending rate to further assist in this monetary policy by tightening the money supply and making the source of funds more expensive. It is simple economics that most people will be less eager to borrow funds as the cost of borrowing increases.

But the question is then- is this is what the Cayman Islands Government wishes too? To dampen the local economy and in effect tighten money supply? In fact, what we have with the scenario of our local banks "mimicking" their USA counterparts is further Cayman Islands cost of living and with it, additional inflationary pressures, when in reality they are external in nature and may not actually be justified.

I will spend very little time on the following questions, but allow me to list them so that I can expand on them:-

1. Where do local banks source the majority of their funds for lending purposes?

2. What is the probable cost of those funds?

3. What is the size and sufficiency of these locally provided funds?

4. What if a local bank had to actually borrow funds from the "open market"?

5. Is there a government agency that causes the local banks to increase their Prime lending rate?

Conclusion and what are the consequences of this dilemma to the Caymanian borrowing public?

Where do local banks source the majority of their funds for lending purposes?

It is my personal belief that the local banks derive their lending source from customer funds on deposit. Thus, if this belief is correct, the local banks can claim to have a very low cost of funds.

What is the probable cost of those funds?

Banks typically carry three sets of accounts that provide a source of funds; these are: - Current accounts (checking), Savings and Term Deposits. Of these accounts, the current and savings category attract a nominal interest rate (about 1.5%) with certain conditions being met- (e.g. minimum cash balances being held and duration). The term deposits attract at best an annual [current rates noted] interest rate of between 4.5% for 1 month deposits to 5.8% for deposits placed for a 1 year term for sums of between $100 to $200 thousand. Because people have short term needs and have to plan accordingly, if one looks at a given balance sheet from a bank you would observe that the "general fund mix" is about a 60% to 40% ratio in favour of term deposits. Using this yard-stick it can be said that the average cost of local funds to banks is in the region of 4%.

What is the size and sufficiency of these locally provided funds?

It is a pity that in these Cayman Islands, readily available and up-to-date economic statistics are still not accessible to the average concerned citizen. In this regard I will have to utilize "out-dated" published data to argue my case. In the 2003 Annual Economic Report as published by the Economics and Statistics Office, the following data is noted:-

[i]   Total loans and advances to the Private Sector by Banks = $1.4billion.

[ii]  Total money supply in the Cayman Islands in 2003 = $4.0billion.

I may be wrong, but a cursory reading of this data leads me to hold to the notion that indeed there exists a sufficient source of local funds to meet the demands of local loans. 

What if a local bank had to actually borrow funds from the "open market"?

I only mention this to say that if such an event were to occur [as it could very well happen] due to a very large building [e.g. Ritz Carlton], then no doubt the bank and group of banks involved would have to set their interest rates to take account of the actual cost of obtaining these additional funds. This additional cost should then be passed on to that specific borrower.

Is there a government agency that causes the local banks to increase their Prime lending rate?

No. Local banks are free to set their local loan interest rates and they appear to be using the "green light" of the US Federal Reserve system to do so. Additionally bearing in mid that there are no "fixed rate" loans available to the local mortgage borrower [i.e. interest rates in Cayman are set as "floating rates"] Cayman banks are at no risk whatsoever in the face of possible future interest rate increases.

Conclusion and what are the consequences of this dilemma to the Caymanian borrowing public?

My conclusion is that I personally am of the belief that there is no justification for our local banks to be charging the high level of loan interest rates that currently prevail.

A margin of 5 percentage points is nothing short of a "wind-fall" profit environment for local banks and it is yet another [and un-necessary!] cost of living for the average consumer of these Cayman Islands.

Consider the following diagram:-



A recent leading local commercial bank revealed the following data relative to their quarterly financial results as to June 31, 2006:

Total interest income = $21.9million

Total interest expense = $8.1million.

Total margin = $13.7million.

Indeed, the sum of $13.7 million in interest margin was 94% of its total expenses.

I also maintain that the present method of allowing local banks to use the policy of the US Federal Reserve [who are trying to tame the US economic inflation levels] is not justifiable and is in fact counter-productive here in our Cayman Islands economic environment. In fact, I would say that these local interest rate increases are causing further local inflation levels as the borrowing public is then forced to pass on these higher borrowing costs to the end customer [i.e. all of us!].

The consequences are beginning to tell. We are now seeing daily bank mortgage foreclosure notices in the local press and the official Gazette.

Banks in the US Federal Reserve System know that their cost of funds, based on current fed-funds rate is 5.25% and while US banks are known to peg their loan rates at 3 percentage points over this rate [for a total of 8.25% currently]; it only takes a walk to the nearest US bank to discover that you can get fixed rate mortgage loans for 30 years at 7% currently.

Noteworthy as well is the fact that banks in the USA actively compete for both Deposit and Loan business.

It is fair to say that mortgage repayments account for the largest portion of the average Caymanian family. So what would happen if rates were lower? The simple table below reflects a comparison in loan interest rates of 9.75% vs. 7% and the resulting "savings" each month to an average borrower.

My conclusion then is very straightforward and hopefully simple:

Banks in the Cayman Islands have no justification for "mimicking" the actions of the US Federal Reserve Bank as it endeavors to address its own fiscal policy.

Banks in the Cayman Islands have an adequate and readily available source of funds to utilize for their loan business and these funds attract a low cost.

The cost of these readily available funds are in the range of 4%; while their charge to borrow such funds are in the range of 9.75% [mortgages only]; thus in this category alone they are enjoying a "wind-fall" profit margin of some 5 percentage points.

In the final analysis banks should be strongly encouraged to lower their loan interest rates and even seek out ways and means of offering, as is the norm in many other financially developed jurisdictions, "fixed rate" loan instruments to the public.