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Definition

The caps rates model

Under this variant form of price leadership model, the bank sets a interest rate caps beyond which the interest can’t move up. If the market interest rate rises, the caps will be effective & bank will continue to finance the borrower even if the caps interest rate is smaller than the market interest rate.

Say in the earlier example Bank Alfala Ltd. Is offering credit to a customer on the term that it will charge prime rate or bank rate plus 2% with caps of 5%. If the short term bank rate is 6%. Then the initial loan pricing will be at (6%+2%) =8%, with the highest interest rate to be charged to the customer will be no more than 8%+5%=13%.

This method is popular in countries where loan interest rate changes continuously. The benefit is that under adverse movement of base interest rate in the economy this model provides some reassurance that the cost of fund will not be more than 13% for the borrower under this agreement.

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