How do the banks set interest rates?

A very useful article posted by Deborah Hyde on Citywire! :

"The Bank of England interest rate has been at record lows for over a year now but few of us have felt the benefit as lenders are lifting rates on borrowing but have passed the cut on to savers. The Bank of England cut rates so why haven't I felt the benefit? The Bank of England's interest rate known as the Bank Rate is not an instruction to banks about what rate they should charge. Instead it is the rate it charges banks and other financial institutions who want to borrow from it.
According to the Bank's website one of the things this is meant to do is affect the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers as well as the price of other things such as shares, the exchange rate and house prices. Lowering or raising interest rates is one way the Bank hopes to affect spending in the economy. The bank tries to control price increases as it tries to keep prices steady. But the move to cut the Bank Rate to 0.5% last year was a response to an extraordinary level of panic in the markets rather than a routine move to keep price rises in check. It was meant to help banks struggling to find anyone to lend money to them, to restore confidence and keep money flowing through the economy.

So why didn't the move help me?

Some people did feel an immediate benefit. People on tracker mortgages saw repayments fall giving them more cash. But for most borrowers rates rose as banks and other lenders passed on rising costs and tried to limit their losses as rising numbers of businesses and individuals declared themselves bankrupt and unable to pay. There is a widening gap between the rates charged to different customers. A new report from HSBC shows that people with plenty of equity in their home - i.e. where the value of their home is substantially above the amount they owe on a mortgage - are being charged much better rates. If you had savings the impact was almost immediate as banks sought to maximise profits by cutting savings rates.

If the Bank of England's rate is lower why are banks charging borrowers more?

Events in Greece and in other southern European nations have reminded people that the financial crisis has not been resolved despite all the stimulus put in place by central banks and governments. Many countries in the developed world are being hobbled by levels of debt that will be difficult to reduce without massive cost-cutting, businesses are still failing, unemployment is between 8 and 20% in the West and economic growth is still anemic in most European countries. The rate banks say they pay for three-month loans in dollars rose above 0.5% on Monday for the first time in 10 months amid concern that the creditworthiness of financial institutions is deteriorating - adding to costs. Others report that not only are costs on the rise but also the market remains closed for all but the safest banks. There are also moves afoot in most countries to force banks to hold more cash and to take less risk. Uncertainty about how much governments will tax the banking sector is adding to nervousness in the sector. All of which means cash is thin on the ground and anyone lending is charging higher rates. There has also been a widespread review of risk. When house prices were soaring, lenders believed that it was relatively safe to lend. Some went as far as lending more than a house was worth because they were confident that their lending was backed by an asset whose value was increasing. The downturn has changed that and there is less confidence around that property prices will rise - which means lenders feel lending has become riskier which in turn means they are charging more.

My credit card rate is nearly 18%, how can that be justified?

The average interest rate being charged by credit card companies has climbed to record highs in recent months. Basically, you are being charged against the risk that you or other people will not be able to pay back what they borrowed. Since credit card lending is unsecured, the companies cannot seize your assets if you cannot or won't pay them back and so they lose all the money that is not paid back. Figures from the Bank of England show that the amount of money credit card companies have had to accept they will not get back has soared in the recession. Since credit card companies often don't have savings businesses that also adds to their risks and their costs, adding to their reasons for charging more.

But why is my saving account paying so little interest?

Unfortunately, the rate banks pay savers does closely reflect the Bank of England Bank Rate. In fact, banks and building societies say they are being generous because they are losing money on what they pay to savers. With lenders worried about funding and in desperate need of deposits, rates are higher for people willing to tie their money up for a few years.

Where will rates go next?

It is highly unlikely that rates for borrowers will fall.
With inflation proving sticky there is increasingly pressure on the Bank of England to lift the Bank rate. A number of members of the bank's rate-setting committee believe it is irresponsible to keep rates so low with prices rising so fast. If the Bank does lift its rate that will be passed onto borrowers - except anyone on a fixed rate. Chancellor George Osborne is hopeful rates will stay low and so far the Bank has indicated there is no likelihood it will lift rates over the next few months. Even so, lenders will keep rates at current levels and may even begin to lift them as new rules come in and banks try to prop up profits and margins. If the wholesale market continues to worry about debt that could also add to the costs for banks and lead to higher rates for borrowers. But some - including former MPC member Charles Goodhart - believe that savers may eventually see rates rise as new rules mean that banks will be desperate to bring in cash to help pay for their lending."