Interest Rate Clustering in UK Financial Services Markets

In applications as diverse as banking, supermarket and catalogue sales, it has been clearly identified that prices have a strong propensity to cluster around certain digits. This study forwards an explanation and empirical investigation of price clustering in retail markets, through an examination of how interest rates cluster in two UK financial services markets. It is proposed that price or interest rate clustering forms in retail markets as firms wish to maximise returns from customers who have difficulties in recalling and processing price information. To compensate for limited recall, individuals use different behavioural strategies, such as rounding and truncating number information, which are recognised by firms when setting prices or interest rates. This theory is developed and tested using a dataset of retail interest rates from the UK which enables interest rate clustering to be viewed in both lending and investment markets, and at different levels of financial involvement. It is found that interest rate clustering occurs in a manner consistent with firms maximising returns from customers who have less ability in recalling and processing number information. Further, the degree of interest rate clustering observed is exaggerated for investors of smaller monetary quantities, for firms which profit maximise and at higher market rates of interest.