Are Prime Rate Changes Asymmetric

M observers have suggested that banks adjust their administered rates asymmetrically, raising loan rates more readily than they lower them. Empirical studies have found support for this claim: Depository institutions appear to move faster to lower deposit rates than to raise them (Neumark and Sharpe, 1992; Diebold and Sharpe, 1990; Hutchison,1995). Such asymmetries, if they exist in the banking system, are of interest to monetary policymakers because they would support Cover’s (1992) argument that monetary policy changes are propagated asymmetrically, with monetary policy tightenings carrying more force than easings of the same magnitude. In addition, because asymmetry in loan interest rates tilted toward slow downward adjustment works to the disadvantage of loan customers, bank-dependent firms as a group are thought to be more vulnerable to the business cycle than firms with direct access to capital markets. Interest rates move in a highly procyclical manner, so that if loan rates are sluggish when moving down, relative to market interest rates, then firms that rely on bank loans will be paying relatively high rates during cyclical downturns, precisely at the time when sales revenues tend to be low. This article tests for the existence of an asymmetric relation between the prime rate and market interest rates and examines whether the effects of such asymmetry are of sufficient magnitude and duration to be of concern. The focus of this article is the bank prime rate, a posted lending rate that ostensibly represents the rate banks offer to their most creditworthy borrowers. It is worth noting that numerous borrowers are able to get loans at less than the prime rate—especially on short-term loans—but, more importantly, many loan rates are tied to the prime, changing by an equal amount whenever the prime rate changes. Because a variety of loan rates—including many credit card balances—are tied contractually to the prime rate, it is an important benchmark. This article reviews how risk aversion on the part of bank managers could lead to asymmetric movement in bank lending rates, such as the prime. Risk aversion, in this context, simply means that managers prefer a smooth profit stream to a volatile one. The article’s main contribution, however, lies in the empirical methodology used to test for asymmetry in the response of the prime rate to shortterm market interest rates. The prime rate changes discretely by multiples of 25 basis points, which implies that changes are relatively infrequent (less than 20 percent of all weeks) and, therefore, newsworthy. Discreteness can confound tests for symmetry, that is, tests for equal responsiveness to pressure to increase or decrease. The pressure to respond to movements in market interest rates does not appear suddenly only in weeks when the prime rate actually changes, so one must find a way to measure how the continuous pressure translates into occasional discrete changes. Empirical analysis of the historical data on the prime rate is hampered because econometric models provide methods for dealing with discrete-valued data and methods for analyzing time-series data, but rarely present methods for confronting the two together. This article addresses the disparate features of the data by employing a dynamic ordered probit model of changes in the prime rate to test for two types of possible asymmetry in the prime. First, the model includes estimated thresholds at which money-center banks change the prevailing prime rate. The thresholds indicate the degree of misalignment between the prime rate and market interest rates needed to induce a discrete change in the prime rate. Second, I estimate separate coefficients for increases and decreases in the short-term interest rate. The difference between these sets of coefficients measures any asymmetry in the generation of underlying pressure for a prime rate change, whereas differences among the threshold coefficients reflect an asymmetry in how such pressure is translated into discrete prime rate changes.