Factors Affecting How Banks Set Their Interest Rates Today
Federal Reserve Requirements
The Fed enforces a minimum reserve requirement, also called a cash reserve ratio, on banks
that are members of the Federal Reserve. These institutions are required to withhold a
percentage of their liabilities in either a cash vault or in a Federal Reserve Bank at all times.
Why does all this matter? Banks that don’t have enough depositors to uphold their reserve
requirement have the option to borrow funds from other banks through short-term loans to
ensure the reserve requirement is met.
Banks are then charged by other banks interest on the loan, which is called the Federal
Funds Rate — this cost of borrowing money is passed on to consumers via bank interest
rates and adjustments on loan products like auto loans and mortgage loans.
Discount Rate
The discount rate is another benchmark which determines how banks set interest rates. In
addition to giving banks the option to lend among one another, the Fed itself provides loans
to help banks meet the reserve requirement at a “discount rate” for the loan.
This direct loan from the Federal Reserve is typically higher than the Federal Funds Rate,
but has recently been lowered to supply institutions with a greater ability to provide loans
to businesses and consumers. The lower the rate banks have to pay when borrowing funds
from the Fed, the more affordable lending interest rates today are for consumers.
Anticipated Inflation
When financial institutions determine the deposit and loan rates offered to customers,
