Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Bank Rate

What it is:

Also called the federal discount rate, the bank rate is the interest rate at which a bank can borrow from the Federal Reserve.
 

How it works (Example):

To understand the bank rate, it is important to understand that banks derive income from making loans. When lending generates profit for banks, they are motivated to lend as much of their deposits as possible. This is a problem when a large number of depositors suddenly want to withdraw their money. To prevent the panic that would naturally occur in this situation, the Federal Reserve maintains a fractional reserve banking system, which requires banks to keep a certain percentage of their deposits in cash.

When a bank is unable to meet the reserve requirement, it can borrow those funds from another bank or directly from the Federal Reserve. Borrowing from the Federal Reserve involves borrowing from the Fed's "Discount Window." The loans are unsecured and are for very short periods (typically overnight).

An increase in the bank rate discourages banks from borrowing to meet reserve requirements, causing them to build up reserves (and thus lend out less money). A reduction in the bank rate has the opposite effect: It encourages banks to borrow to meet reserve requirements, which makes more money available for lending.

Why it Matters:

The Federal Reserve sets the bank rate, and by doing so it influences the rate at which banks also borrow from each other (the federal funds rate). So if the bank rate is lower than the federal funds rate, banks will probably prefer to borrow from the Federal Reserve when they need loans. This puts downward pressure on the federal funds rate.

Conversely, if the bank rate is higher than the federal funds rate, banks will probably borrow from each other rather than from the Federal Reserve. This puts upward pressure on the federal funds rate. In either case, the Federal Reserve can trigger a change in the federal funds rate by changing the discount rate. This is why the bank rate and the federal funds rate are generally closely correlated.

Because the increase in the supply of funds available for lending puts downward pressure on interest rates, changes in the bank rate can have widespread economic effects. Manipulation of the federal funds rate is one of three primary methods the Federal Reserve uses to control the money supply (the other two involve changing reserve requirements and buying or selling U.S. Treasuries on the open market).

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