Why Are Lending Rates Falling Less Than Cuts In Interest Rates?

The Star today has a report on why lending rates have lagged cuts in interbank rates over the past few months. Which is fine - there are indeed good technical reasons for such lags and I've experience enough in the banking industry to readily believe why this is happening.

What isn't explained is why lending rate cuts are also less than the fall in interbank rates. I've covered this topic before, but it bears repeating. Borrowing costs are not fully reflecting the drop in bank funding costs - in effect, banks have increased their margin on lending to the point where the real interest rate (as opposed to the nominal rate) is actually higher now than at the beginning of the downturn:




That makes little sense to me, both from a policy perspective as well as a business perspective. We see here a conflict of incentives that could bite the banks if economic conditions continue to deteriorate. On the one hand, there is the desire to buffer income against the possiblity of loan defaults, which to be fair are likely to rise this year.

On the other hand, higher real interest rates reduces the propensity to borrow and invest, thus reducing the pace and trajectory of potential economic recovery, as well as to increase the systemic probability of the very loan defaults that banks fear. By acting to buffer potential losses, banks may actually be encouraging it to happen instead.