Bank Rate - Explained
What is a Bank Rate?
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Table of ContentsWhat is a Bank Rate?How Does a Bank Rate Work?Discount Rate Versus Overnight RateHow the Bank Rate Affects Consumer Interest Rates
What is a Bank Rate?
A bank rate refers to the interest rate that the central bank charges commercial and domestic banks for lending funds to them. It is also called the discount rate, this rate is charged on all loans issued to commercial banks. One major way the central bank influences the economy is through the bank rate. This interest rate is often low and in turn gives room for the expansion of the economy.
How Does a Bank Rate Work?
In the United States, the bank rate is called the federal funds rate or the discount rate. This interest rate is set by the Board of Governors of the Federal Reserve System. It serves as a benchmark for interest collection on loans that the central bank advances to commercial banks. This rate is also a major requirement for banks as it helps keep the economy in check. Aside from the federal funds rate, the treasury security that the Federal Open Market Committee (FOMC) trades also have a significant impact on the economy. These are parts of the monetary policy adopted in the United States.
Discount Rate Versus Overnight Rate
The discount rate or bank rate is not the same as the overnight rate. While the bank rate refers to the rate the central bank charges commercial banks for lending them funds, the overnight rate is charged by banks when they borrow other banks funds. To be clear, bank rate is charged by the Central Bank to banks while the overnight rate is charged by a bank to another bank. There are cases where banks borrow funds from each other and the bank lending the money charges a percentage as interest called the overnight rate. Usually, if the bank rate is lower than the overnight rate, banks go to the central bank for funding.
How the Bank Rate Affects Consumer Interest Rates
Bank rates or discount rates have significant effects in the consumer interest rates. Usually, most banks charge their customers using an interest rate close to the overnight rate, however, this is only applicable for customers with good credit rating. Customers that do not have high creditworthiness are exposed to higher invest rates when they go to banks for funding. Bank rate directly affects consumer interest rates, the higher the bank rate, the higher the consumer interest rates. When central banks also charge low bank rates, consumer interest rates are lower.