What Is a Bank Rate?
A bank rate is the interest rate at which a nation's central bank lends money to domestic banks, often in the form of very short-term loans. Managing the bank rate is a method by which central banks affect economic activity. Lower bank rates can help to expand the economy by lowering the cost of funds for borrowers, and higher bank rates help to reign in the economy when inflation is higher than desired.
Key Takeaways
- The bank rate is the interest rated charged by a nation's central bank for borrowed funds.
- The Board of Governors of the U.S. Federal Reserve System set the bank rate.
- The Federal Reserve may increase or decrease the discount rate to slow down or stimulate the economy, respectively.
- There are three types of credit issued by the Federal Reserve to banks: primary credit, secondary credit, and seasonal credit.
- Contrary to the bank rate, the overnight rate is the interest rate charged by banks loaning funds to each other.
How Bank Rates Work
The bank rate in the United States is often referred to as the discount rate. In the United States, the Board of Governors of the Federal Reserve System sets the discount rate as well as the reserve requirements for banks.
The Federal Open Market Committee (FOMC) buys or sells Treasury securities to regulate the money supply. Together, the discount rate, the value of Treasury bonds, and reserve requirements have a huge impact on the economy. The management of the money supply in this way is referred to as monetary policy
Types of Bank Rates
Banks borrow money from the Federal Reserve to meet reserve requirements. The Fed offers three types of credit to borrowing banks: primary, secondary, and seasonal. Banks must present specific documentation according to the type of credit extended and must prove they have sufficient collateral to secure the loan.
Primary Credit
Primary credit is issued to commercial banks with strong financial positions. There are no restrictions on what the loan can be used for, and the only requirement for borrowing funds is to confirm the amount needed and loan repayment terms.
Secondary Credit
Secondary credit is issued to commercial banks that do not qualify for primary credit. Because these institutions are not as sound, the rate is higher than the primary credit rate. The Fed imposes restrictions on use and requires more documentation before issuing credit. For instance, the reason for borrowing the funds and a summary of the bank's financial position are required, and loans are issued for a short-term, often overnight.
Seasonal Credit
As the name suggests, seasonal credit is issued to banks that experience seasonal shifts in liquidity and reserves. These banks must establish a seasonal qualification with their respective Reserve Bank and be able to show that these swings are recurring. Unlike primary and secondary credit rates, seasonal rates are based on market rates.
Bank Rate vs. Overnight Rate
The discount rate, or bank rate, is sometimes confused with the overnight rate. While the bank rate refers to the rate the central bank charges banks to borrow funds, the overnight rate—also referred to as the federal funds rate—refers to the rate banks charge each other when they borrow funds among themselves. Banks borrow money from each other to cover deficiencies in their reserves.
The bank rate is important since commercial banks use it as a basis for what they will eventually charge their customers for loans.
Banks are required to have a certain percentage of their deposits on hand as reserves. If they don't have enough cash at the end of the day to satisfy their reserve requirements, they borrow it from another bank at an overnight rate. If the discount rate falls below the overnight rate, banks typically turn to the central bank, rather than each other, to borrow funds. As a result, the discount rate has the potential to push the overnight rate up or down.
As the bank rate has such a strong effect on the overnight rate, it also affects consumer lending rates. Banks charge their best, most creditworthy customers a rate that is very close to the overnight rate, and they charge their other customers a rate that is a bit higher.
For example, if the bank rate is 0.75%, banks are likely to charge their customers relatively low-interest rates. In contrast, if the discount rate is 12% or a similarly high rate, banks are going to charge borrowers comparatively higher interest rates.
Example of Bank Rates
A bank rate is the interest rate a nation's central bank charges other domestic banks to borrow funds. Nations change their bank rates to expand or constrict a nation's money supply in response to economic changes.
In the United States, the discount rate has remained unchanged at 0.25% since March 15, 2020. In response to the global financial crisis, the Fed lowered the rate by 100 basis points. The main goal was to stabilize prices, prevent rises in unemployment, and encourage the use of credit among households and businesses.
Among all nations, Switzerland reports the lowest bank rate of -0.750%, and Turkey—known for having high inflation— has the highest at 19%.
14%
The highest United States discount rate ever declared (June 1981).
What Happens When the Central Bank Increases the Discount Rate?
To counter inflation, the Central bank may increase the discount rate. When increased, the cost to borrow funds increases. In turn, disposable incomes decrease, it becomes difficult to borrow money to purchase homes and cars, and consumer spending decreases.
If the Fed Lowers the Federal Funds Rate, What Happens to Savings Accounts?
The federal funds rate is the interest rate banks charge each other to borrow funds, whereas the discount or bank rate is the rate the Federal Reserve charges commercial banks to borrow funds. A lowered discount rate correlates to lower rates paid on savings accounts. For established accounts with fixed rates, the lowered discount rate has no effect.
What Interest Rate Does a Commercial Bank Pay When It Borrows From the Fed?
The interest rate a commercial bank pays when it borrows from the Fed depends on the type of credit extended to the bank. If issued primary credit, the interest rate is the discount rate. Banks that do not qualify for primary credit may be offered secondary credit, which has a higher interest rate than the discount rate. Seasonal credit rates fluctuate with the market and are tied to it.
The Bottom Line
A bank rate is the interest rate a nation's central bank charges to its domestic banks to borrow money. The rates central banks charge are set to stabilize the economy. In the United States, the Federal Reserve System's Board of Governors set the bank rate, also known as the discount rate.
Banks request loans from the central bank to meet reserve requirements and maintain liquidity. The Federal Reserve issues three types of credit according to the financial position of the bank and their needs. In contrast to the bank rate, the overnight rate is the interest rate fellow banks charge each other to borrow money.
In response to the global crisis, many central banks have changed their bank rates to stimulate and stabilize the economy. In March 2021, the United States responded by lowering its discount rate to 0.25%.
