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Question-- So I'm not a finance quant or anywhere near conversant in the intricacies of finance, so I really don't understand what seems to be an important ques

Question-- So I'm not a finance quant or anywhere near conversant in the intricacies of finance, so I really don't understand what seems to be an important question: Why do banks have to follow the federal rate for certain types of loans? IIRC the rate is used for interbank loans against federal reserve deposit requirements, but why would they follow the Fed rate for this rather than some other market force? I don't think it's required by statute (is it?). What, if anything, prevents banks from ignoring federal benchmark rates all together?

wccrawford 5y ago
Competition? Profit motive? If they go too far one way, people will use other banks. If they go too far the other, they waste money. Also, there comes a point where they could just invest that money in someone else rather than offer the service themselves, and make more money. That keeps things from going too far that direction. And finally... Deciding things is hard. When someone else decides things for everyone, legally, it's an easy choice to follow it. Most of the time that's price fixing and is illegal.
- djyaz1200 5y ago
  "Most of the time that's price fixing and is illegal." Bingo! That's the answer, the fed funds rate is a price fixing tool. Banks via the federal reserve governors meet to decide the base interest rate from which most other interest rates are derived. Aka the "price" of money. This is done to optimize the rent seeking activity of loans. The banks want to optimize how much interest they extract from the productive economy without harming it to the degree it stops growing or shrinks. Related, most people think the Fed IS the government but it is not... it's banks... https://www.stlouisfed.org/in-plain-english/who-owns-the-federal-reserve-banks https://www.stlouisfed.org/in-plain-english/who-owns-the-fed...
- ineedasername 5y ago
  So, theoretically, banks could lend at different rates but for various practical reasons they don't?
timr 5y ago
Short answer: loans get packaged into bonds. Bonds get sold at auction, and the market prices them according to their risk relative to treasury bonds. Banks don't have to follow the federal rate. It's the "zero risk" rate that anyone can get. Beyond that, higher return generally means higher risk, with the risk premium set by the market. If you originate a loan with a wildly low APR, then you'll certainly get borrowers, but nobody will buy the debt from you, and you'll lose money. If you try to originate mortgages with higher than market APR, you won't have any takers.

wccrawford 5y ago

Competition? Profit motive? If they go too far one way, people will use other banks. If they go too far the other, they waste money. Also, there comes a point where they could just invest that money in someone else rather than offer the service themselves, and make more money. That keeps things from going too far that direction. And finally... Deciding things is hard. When someone else decides things for everyone, legally, it's an easy choice to follow it. Most of the time that's price fixing and is illegal.

djyaz1200 5y ago
"Most of the time that's price fixing and is illegal." Bingo! That's the answer, the fed funds rate is a price fixing tool. Banks via the federal reserve governors meet to decide the base interest rate from which most other interest rates are derived. Aka the "price" of money. This is done to optimize the rent seeking activity of loans. The banks want to optimize how much interest they extract from the productive economy without harming it to the degree it stops growing or shrinks. Related, most people think the Fed IS the government but it is not... it's banks... https://www.stlouisfed.org/in-plain-english/who-owns-the-federal-reserve-banks https://www.stlouisfed.org/in-plain-english/who-owns-the-fed...
ineedasername 5y ago
So, theoretically, banks could lend at different rates but for various practical reasons they don't?

timr 5y ago

Short answer: loans get packaged into bonds. Bonds get sold at auction, and the market prices them according to their risk relative to treasury bonds. Banks don't have to follow the federal rate. It's the "zero risk" rate that anyone can get. Beyond that, higher return generally means higher risk, with the risk premium set by the market. If you originate a loan with a wildly low APR, then you'll certainly get borrowers, but nobody will buy the debt from you, and you'll lose money. If you try to originate mortgages with higher than market APR, you won't have any takers.