Bank Rate: Definition, How It Works, Types, and Example

What Is a Bank Rate?

A bank rate is the interest rate at which a nation's central bank lends money to domestic banks. This is often in the form of very short-term loans. Managing the bank rate is a method by which central banks can affect economic activity.

Lower bank rates can help to expand the economy by lowering the cost of funds for borrowers. Higher rates help 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 discount rate. The Board of Governors of the Federal Reserve System sets the discount rate in the United States, as well as the reserve requirements for banks.

The Federal Open Market Committee (FOMC) buys or sells Treasury securities to regulate the money supply. The discount 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

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 they must prove that they have sufficient collateral to secure the loan.

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. The only requirement for borrowing funds is to confirm the amount needed and the loan repayment terms.

Secondary Credit

Secondary credit is issued to commercial banks that don't qualify for primary credit. These institutions aren't as sound so the rate is higher than the primary credit rate. The Fed imposes restrictions on use and requires more documentation before issuing credit. The reason for borrowing the funds and a summary of the bank's financial position are required. Loans are issued for a short term, often overnight.

Seasonal Credit

Seasonal credit is issued to banks that experience seasonal shifts in liquidity and reserves, as the name suggests. These banks must establish a seasonal qualification with their respective Reserve Banks and be able to show that these swings are recurring. Seasonal rates are based on market rates, unlike primary and secondary credit rates.

Bank Rate vs. Overnight Rate

The discount or bank rate is sometimes confused with the overnight rate. 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 from each other. Banks borrow money from each other to cover deficiencies in their reserves.

Banks are required to have a certain percentage of their deposits on hand as reserves. They'll borrow the money from another bank at an overnight rate if they don't have enough cash at the end of the day to satisfy their reserve requirements. Banks typically turn to the central bank rather than each other to borrow funds if the discount rate falls below the overnight rate. The discount rate has the potential to push the overnight rate up or down as a result.

The bank rate has such a strong effect on the overnight rate that it also affects consumer lending rates. Banks charge their best, most creditworthy customers a rate that's very close to the overnight rate and they charge their other customers a rate that's a bit higher.

Banks are likely to charge their customers relatively low interest rates if the bank rate is 0.75% but they're going to charge borrowers comparatively higher interest rates if the discount rate is 12% or a similarly high rate.

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.

As of June 2024, the discount rate in the United States has remained unchanged at 5.50% since March 28, 2023.

Switzerland reports the lowest bank rate among all nations at 1.50% as of June 2024. Turkey, known for having high inflation, has the highest at 50.0%.

The Bottom Line

A bank rate is the interest rate that a nation's central bank charges to its domestic banks to borrow money. The rates that central banks charge are set to stabilize the economy. The Federal Reserve System's Board of Governors sets the bank rate in the United States, also known as the discount rate.

Banks request loans from the central bank to meet reserve requirements and maintain liquidity. The Federal Reserve issues three types of credit according to the financial position of the bank and their needs. The overnight rate is the interest rate that fellow banks charge each other to borrow money.