Commercial Banking Price Leadership

Banks then use this money to make loans available to household and corporate borrowers. They then earn their profits by lending at an interest rate higher than the rates they pay on their deposits.

The largest commercial banks in the US bank of America, Bankers Trust Corporate, Chemical Bank, Chase Manhattan Bank, Citibank, Morgan Guaranty Trust Corporation and Wells Fargo, and many others compete with each other to make loans available to large corporate clients. The interest rates they charge corporate clients for loans are the main form of competition, a price competition, in this case. When this competition becomes aggressive, the interest rates they charge have a tendency to fall, and so do their profits. To avoid this aggressive competition, a form of price leadership was put into place.

The interest rate charged by banks to large corporate clients is called the prime rate. This rate is well known and often quoted in newspapers. Most large banks charge the same or very close of the same price for it. Frequent changes in the rate are avoided in order to avoid destabilization and competitive warfare. When money market conditions changes enough and other interest rates have risen or fallen substantially, prime rate changes occurs.

Only then, one of the major banks announces a change in its prime rate, and the other banks quickly follow suit. Banks take turns as leaders from time to time, but when a changed is announced, the other banks will immediately follow within two or three days.