bank rates

Definition: Bank rate is the rate charged by the central bank for lending funds to commercial banks.

Description: Bank rates influence lending rates of commercial banks. Higher bank rate will translate to higher lending rates by the banks. In order to curb liquidity, the central bank can resort to raising the bank rate and vice versa.

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

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

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.1

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, 2020.2 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.