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- According to the U.S. Federal Reserve's Quarterly Survey of Terms of Business Lending, which surveys bank lending policies across the country, only about a third of the value of all corporate lending is priced in relation to the prime rate. According to the Federal Reserve, small domestic banks tend to price their loans in relation to the prime rate but the large international banks mostly use the Libor. Nevertheless, every bank in the United States sets its own prime rate.
- The prime rate reported on the news is established through a survey of the 10 largest banks in the country, taken by The Wall Street Journal. When at least seven of those banks move their prime rates, The Wall Street Journal will publish that rate as the prime rate. What is referred to as the Fed, national or United States prime rate is actually the Wall Street Journal prime rate as published in its East Coast edition.
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The Federal Reserve manages two important interest rates: the discount rate and the federal funds target rate. In an emergency or during a financial crisis, Federal Reserve member banks may borrow money at the fed discount window. This discount rate is the lowest rate available, and the discount window is considered a lending source of last resort.
The Federal Reserve Board of Governors meets quarterly to review the economy and set the fed funds target rate. If inflation appears to be a trend, the Board of Governors will raise the fed funds target rate by 25 basis points to as much as a full percentage point. If deflation is its worry or if the economy is slowing, it will similarly lower the target rate. - Banks borrow the money they lend, and they make a profit off the spread between their cost of funds interest rate and the interest rate they charge on the money they loan to their customers. A banking rule of thumb states that in order to be profitable a bank must charge at least 200 basis points (2 percent) more for its loans than it pays for the money. Therefore, if a bank pays 4 percent for fed funds and 6 percent for certificates of deposit, its average cost of money might be 5.5 percent and it would have to lend that money at 7.5 percent or higher in order to make a profit on the loan. This lowest profitable loan rate is what a bank would call its own prime rate. It is the rate at which it lends money to its prime customers.
- The prime rate functions more as an indicator of the level or direction of interest rates than as a firm lending rate available to a bank's best customers. Some loans are made at rates below prime. Consumer loans usually are advertised at prime plus a certain percentage. This protects the lender in cases when the Fed unexpectedly raises the fed funds target rate and at least seven of the country's top 10 banks raise their prime lending rates accordingly. Sometimes only two or three banks will raise their rates, and in that case the prime rate as reported in The Wall Street Journal will not change.
