A bank rate is the interest rate charged by a nation’s central bank to commercial banks and other depository institutions when they borrow funds. The bank rate is set by each nation’s central bank and changes based on monetary policy goals.
Below we’ll dive into what the bank rate is, how it works, and why it may be important for you to understand.
Definition and Examples of a Bank Rate
A bank rate is the interest rate banks pay on temporarily loaned funds from the central bank. The loan amount multiplied by the bank rate is the total amount of interest banks are charged on their loans.
Bank rates are called different names in different countries. For example, in the United States, the central bank is the Federal Reserve and its bank rate is called the discount rate. For countries that use the euro and borrow from the European Central Bank, the bank rate is called the marginal lending facility rate.
- Alternate names: discount rate, marginal lending facility rate
How a Bank Rate Works
Central banks set their own bank rates. In the U.S., the discount rate is one of the tools the central bank—the Federal Reserve—uses to conduct monetary policy. A lower discount rate encourages banks to borrow funds from the Federal Reserve, whereas a higher discount rate makes it more expensive for banks to borrow funds.
Central banks will change their bank rate depending on whether the economy is in an expansion, contraction, or recession period.
The discount rate is usually set at a higher level than other interest rates, like the federal funds rate, which is the interest rate banks charge one another to borrow funds. The reason the discount rate is usually higher is because the Federal Reserve only wants to be a backup source of funding for commercial banks and other depository institutions. The Federal Reserve prefers banks to borrow from one another so they can monitor one another’s financial position and risk.
Types of Bank Rates
There are three types of bank rates, or discount rates, in the U.S.
Banks with strong financial positions receive this rate. In the U.S., the Federal Reserve sets the primary credit rate. For example, in July 2021, the primary credit rate was set at 0.25%.
Banks that do not qualify for primary credit receive this rate and it is usually 50 basis points higher than the primary rate.
Banks that have a pattern of intra-year fluctuations in funding obtain this rate. These fluctuations are often caused by a bank’s connection to industries such as construction or farming. The seasonal credit rate is reset every two weeks and is the average of the daily effective federal funds rate and the rate on three-month certificates of deposit (CDs) over the prior 14-day period. It is then rounded to the nearest 5 basis points.
How Loans From the Central Bank Work
The Federal Reserve lends to banks and other depository institutions via the discount window. This is the program that allows banks to borrow funds from the Federal Reserve and pay the discount rate. Banks can borrow funds from the Federal Reserve for up to 90 days. To borrow funds, banks must pledge collateral in the form of loans or securities. If a bank does not return the funds, the Federal Reserve keeps the collateral. This minimizes the risk of the Federal Reserve losing money.
Since 1913, the Federal Reserve has never lost money on discount-window loans.
When a bank borrows funds via the discount window, the Federal Reserve increases the reserves for the bank, which in turn increases the ability for the bank to lend money. If a bank lends money, the money supply will increase.
Why Do Banks Borrow From the Central Bank?
Banks borrow from the central bank to address temporary problems with funding. Banks and other depository institutions must be in compliance with reserve requirements, so if too many depositors withdraw money or the bank issues too many loans, they will have to borrow to stay within the legal reserve requirement.
In the U.S., banks have two options for borrowing:
- They can borrow from other banks overnight and pay the federal funds interest rate in return for the borrowed funds.
- They can borrow from the Federal Reserve and pay the discount rate.
The federal funds interest rate is typically lower than the discount rate, so banks often seek this option first. For example, in July 2021, the fed funds rate was 0.10% and the primary discount rate was 0.25%.
For example, if Bank A is short on funds and needs to borrow to meet the reserve requirements, they could go to Bank B and inquire about borrowing funds. If Bank B does not have extra funds to loan or if Bank B believes Bank A may not pay back the loaned funds because it is not in a strong financial position, then Bank A needs to borrow funds elsewhere, such as from the Federal Reserve.
The Federal Reserve is a backup source of funding for banks but often becomes a main source of funding during crises or an economic downturn. During crises, it is difficult for banks to know if other banks are financially sound, so bank-to-bank lending occurs less. However, the Federal Reserve has detailed bank information and is readily available to lend during tough times. This is one of the many reasons why the Federal Reserve is often called a “lender of last resort.”
- A bank rate is the interest rate charged when banks borrow funds from the central bank.
- Central banks set their own bank rates and change the rate depending on economic conditions to encourage or discourage borrowing.
- The bank rate for the Federal Reserve is called the discount rate.
- Banks tend to borrow more from the Federal Reserve during economic crises.