I know what the fed funds rate is. My question is WHY do they all follow it? If I’m selling something and my competitors are at 7%, why wouldn’t a bank do 6% to capture the market?
In: Economics
To answer your final question – because then all your competitors would do 6% and then you and all your competitors would be 1% worse off.
They depend on the fed rates because that’s where they get their funds from to loan to you. If they loan to you at a lower rate than the fed rate, they are losing money. That sets the floor.
Free market idealists like to espouse their religion that free market competition invariably leads to lowest prices. In reality, market players often realise they are best off reaching an unspoken truce in which they don’t attack one another.
A bank has a pile of money, and their job is to do things with it that make a return on it. The easy thing to do would be to buy government bonds, which are very safe (because they’re guaranteed by the US government) and also have a guaranteed return. This return is known as the “risk-free rate”.
If they can lend some of that money to individuals who will pay a little more than the government, though, then they will do that because they can make a little bit more money for their shareholders. But, there’s some risk in doing that – for every 1000 people they loan money to, a handful will default on their payment obligations. So they have to make sure the individuals pay enough more than the government would, to cover for the fact that some will default, and so the banks can still come out ahead vs just lending that money to the government where there is zero risk.
On top of that, every time a bank has issued a bunch of debt of a similar kind, they can bundle it up and resell it for a small profit in the secondary (resellers) market, and then take the money they get for doing that and start issuing more loans. They can only sell these loans this if the debt they’ve issued meets certain criteria, which — you guessed it — includes charging enough to make sure they can cover for the occasional default AND so that the buyer can make a little money too.
The amount extra they have to charge goes up and down a little bit depending on how trustworthy the borrower is, as measured by the value of their house that’s securing the loan relative to the size of their loan, and depending on their credit score, which is a measure of how reliable they are at paying back loans.
Banks tend to compete by lower their rates as close as they can to the point at which they can no longer bundle and resell the loans, which has a margin on top of the risk-free rate because of the default risk, the costs of administering the loans, and the fact that they’re reselling the loans to the secondary market and both the bank and the secondary buyer need to make a little money on them.
Banks are the middleman for government loans.
The fed loans money to the bank, and the bank re-loans it to a customer.
The bank’s rates mirror the fed’s rates because they are the same rate, plus a small markup so the bank makes a profit.
They do. There is variation in mortgage rates between different banks. But it’s not very big because they all still have to make money. If they loan at a lower interest rate then they get more loan customers…but they don’t make as much money.
The money they loan out has to come from somewhere, or at least a fraction of it. So they need to pay interest to their savings customers to get their money, or borrow it from another bank. No bank will loan at cheaper than the fed rate (otherwise you’d just borrow from the fed), so that sets the lower limit that the bank can borrow money so they need to charge more than that to make money.
If they loan our money that people have deposited, they need to get more in the loan than they’re paying the depositors interest. So if they lower their loan rate then they also have to lower their savings rate to maintain profit, but with lower savings rates less people will deposit there.
It all has to balance, they’re all competing in mostly the same space, and it’s all sitting on the floor of the fed rate.
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