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.
How Bank Rates Work
The bank rate in the United States is often referred to as the federal funds rate or 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 federal funds 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
Special Considerations: Discount 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 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 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 reserve. 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 the 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 customer's 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.