<p>The Prime Rate in the US is supposed to represent the rate at which banks make loans to customers.  For many years is has been set at Fed Funds+300bp, whereas the rate at which banks actually make loans varies a lot depending on the creditworthiness of the borrower.</p>

CC BY-SA 4.0
2024-08-10T17:52:00.250Z
You see, the problem is that you didn't answer "WHY??" they set it pegged to the federal funds rate.
Jerry W
CC BY-SA 4.0
2021-01-25T03:10:59.670Z
2021-01-25T03:10:59.670Z
dm63
<p>Below is a link to a FRED chart showing the history of Prime rate to the effective Fed funds rate:</p>
<p><a href="https://fred.stlouisfed.org/graph/fredgraph.png?g=AkrK" rel="nofollow noreferrer">https://fred.stlouisfed.org/graph/fredgraph.png?g=AkrK</a></p>
<p>One could build a second graph as the difference between Prime and Fed funds rates to see when the custom emerges where the Prime rate is pegged 3% above Fed funds. This pattern appears to be established in the late 1980s to early 1990s. I have never found a paper or theory describing this feature of Prime rate being pegged rather variable as a markup over federal funds in recent history as opposed to the volatile money and credit markets in the not so distant past.</p>
<p>The overnight purchase and sale (loans) of federal funds are similar to short term overdraft privileges one would have at a bank. The discount window loans of federal funds provided by the central bank are given against collateral and at a penalty rate above the effective fed funds rate. Banks can borrow from other banks and non-banks using other money market instruments including repo liabilities, eurodollars, etc. This is an interesting custom because banks in essence as a group create deposits by investing in assets and then must share income with non-bank investors in the money markets to keep interbank payments flowing in the pool of federal funds. I have tried to isolate the mechanism which gives banks the ability to create deposits from &quot;thin air&quot; and it seems to be the overdraft available at other banks and/or the central bank but I can't verify this intuition with available data.</p>
<p>The bank or any other sophisticated financial intermediary is basically able to borrow funds in the wholesale money markets, to lend funds at a retail markup, and to thereby capture the difference between interest income and interest expense as the net interest income. In an economy where credit is being rationed the banks tend to lose interest income and to increase fees to offset the loss of interest income.</p>
<p>Large sophisticated nonbank firms could borrow in money markets or bond markets for some purposes at lower interest rates than would be offered by banks. So banks and financial intermediaries make the markup for underwriting loans to customers who lack the sophistication or ability to raise funds at lower interest rates.</p>

CC BY-SA 4.0
2021-01-25T04:10:59.513Z
2021-01-25T04:10:59.513Z
SystemTheory
<p>What is the right framework to think about the prime rate in relation to the fed funds rate?</p>
<p>Idea 1: A bank is safer to lend to than even trustworthy institutions so there's a premium on prime rates. Why is this true though? I could imagine several institutions with great credit could be safer than some banks. Is there something that makes a loan to a bank safer?</p>
<p>Idea 2: A bank can borrow at the fed funds rate. So banks could borrow at fed funds and lend to customers at higher rates. If their borrowing rate changes, their lending rate changes with it to reflect their cost. Perhaps though this is uncommon because lending on borrowed capital would inherently have a smaller margin than lending on unborrowed capital, so it would be hard to compete with borrowed capital.</p>
<p>Basically the causality can come from the fact they can lend at the fed funds rate or borrow.</p>

CC BY-SA 4.0
2024-09-26T17:06:50.437Z
Prime rate has just become a marketing number that moves broadly in parallel with money market and federal reserve rates.  But since banks now lend to some borrowers at less than "prime" rates, it is no longer their best rate.  This marketing distortion explains why the prime margin is wider than it was in the 1970s and 1980s.
Henry
<fed-funds-rate>
Why is the prime rate typically 3% higher than the fed funds rate?
curiousgeorge
# Why is the prime rate typically 3% higher than the fed funds rate?

(Asked by: username_0 on 2021-01-24)

What is the right framework to think about the prime rate in relation to the fed funds rate?

Idea 1: A bank is safer to lend to than even trustworthy institutions so there's a premium on prime rates. Why is this true though? I could imagine several institutions with great credit could be safer than some banks. Is there something that makes a loan to a bank safer?

Idea 2: A bank can borrow at the fed funds rate. So banks could borrow at fed funds and lend to customers at higher rates. If their borrowing rate changes, their lending rate changes with it to reflect their cost. Perhaps though this is uncommon because lending on borrowed capital would inherently have a smaller margin than lending on unborrowed capital, so it would be hard to compete with borrowed capital.

Basically the causality can come from the fact they can lend at the fed funds rate or borrow.

**Tags:** fed-funds-rate

> **Comments:**
> **username_1**: Prime rate has just become a marketing number that moves broadly in parallel with money market and federal reserve rates.  But since banks now lend to some borrowers at less than "prime" rates, it is no longer their best rate.  This marketing distortion explains why the prime margin is wider than it was in the 1970s and 1980s.  

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## 2 answers

### Answer by username_2 on 2021-01-25. Score: 1

The Prime Rate in the US is supposed to represent the rate at which banks make loans to customers. For many years is has been set at Fed Funds+300bp, whereas the rate at which banks actually make loans varies a lot depending on the creditworthiness of the borrower.

> **Comments:**
> **username_3**: You see, the problem is that you didn't answer "WHY??" they set it pegged to the federal funds rate.  

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### Answer by username_4 on 2021-01-25. Score: 0

Below is a link to a FRED chart showing the history of Prime rate to the effective Fed funds rate:

<https://fred.stlouisfed.org/graph/fredgraph.png?g=AkrK>

One could build a second graph as the difference between Prime and Fed funds rates to see when the custom emerges where the Prime rate is pegged 3% above Fed funds. This pattern appears to be established in the late 1980s to early 1990s. I have never found a paper or theory describing this feature of Prime rate being pegged rather variable as a markup over federal funds in recent history as opposed to the volatile money and credit markets in the not so distant past.

The overnight purchase and sale (loans) of federal funds are similar to short term overdraft privileges one would have at a bank. The discount window loans of federal funds provided by the central bank are given against collateral and at a penalty rate above the effective fed funds rate. Banks can borrow from other banks and non-banks using other money market instruments including repo liabilities, eurodollars, etc. This is an interesting custom because banks in essence as a group create deposits by investing in assets and then must share income with non-bank investors in the money markets to keep interbank payments flowing in the pool of federal funds. I have tried to isolate the mechanism which gives banks the ability to create deposits from "thin air" and it seems to be the overdraft available at other banks and/or the central bank but I can't verify this intuition with available data.

The bank or any other sophisticated financial intermediary is basically able to borrow funds in the wholesale money markets, to lend funds at a retail markup, and to thereby capture the difference between interest income and interest expense as the net interest income. In an economy where credit is being rationed the banks tend to lose interest income and to increase fees to offset the loss of interest income.

Large sophisticated nonbank firms could borrow in money markets or bond markets for some purposes at lower interest rates than would be offered by banks. So banks and financial intermediaries make the markup for underwriting loans to customers who lack the sophistication or ability to raise funds at lower interest rates.


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