The Meaning of Benchmark Prime Lending Rate
The prime interest rate represents a floor value for the interest charged on a loan. A bank will not go below this value, and virtually all customers will have to pay more interest than this to compensate the bank for the risk that they will default on the loan, called a "risk premium".
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Prime Interest Rate
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An individual bank's interest base, on top of which it layers additional interest based on the estimated risk of default, is called its prime interest rate. This is not to be confused with the benchmark prime interest rate. The benchmark is a useful tool banks used to determine what a reasonable prime lending rate (PLR) for the bank is. There are a variety of benchmark rates used: Which ones depends on the preferences of the lending institution.
Prime Interest Rate Benchmarks
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One commonly used benchmark for PLRs is LIBOR. LIBOR stands for London Interbank Offered Rate. This is the rate at which banks in London loan each other funds in the money market. This is similar to the federal funds rate in the United States (though not identical). Due to Britain's status as a large economy with a stable government and strong trade relationship with many other nations, this rate serves as a useful "yardstick" for setting a good interest base for financial institutions. Many other benchmarks are used as well, COFI, WSJ Prime Rate, Federal Funds Rate and the 11th District Cost of Funds.
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How Rates Are Set
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While some of the rates mentioned could be set by fiat, according to the authority of those managing the rates, few are. The rates are heavily influenced by market forces. Economic growth or contraction, money supply, exchange rates and trade balances are just a few of the macroeconomic factors influencing interest rates. To make matters even more complicated, the Federal Funds Rate is sometimes changed by the Federal Reserve Bank of the United States in an attempt to alter elements of the economy, like the money supply.
How Benchmarks Are Used
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The Federal Funds Rate has a more powerful influence than the other benchmarks on the banking industry in the United States. Changes in the rate affect the ability of banks to transfer cash between each other in order to fulfill their required reserves. As such, when this rate increases, so do the rates of virtually all loans. Additionally, the returns on bank deposit products like certificates of deposit, money market accounts and savings accounts will decrease.
Controversy
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While banks use the benchmark rates to set interest rate bases for loans and this value is (mostly) organically derived from market forces, the federal funds rate is somewhat of an exception. The Fed manipulates this rate intentionally to alter the economy, and this has drawn some criticism. When the Fed alters the rate to increase the flow and supply of money in the economy, this is called expansionary monetary policy and some economists argue that this can cause both inflation and deficits. These critics state that despite occasional crises, the economy in the long run, will stabilize and benchmarks should emerge naturally.
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References
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