Prime Rate

A borrower's loan agreement adjusts with the prime rate. Who sets the prime rate?

1. A.The Federal Open Market Committee, at each of its regularly scheduled meetings.Wrong. The FOMC sets a target for the federal funds rate and publishes no lending rate for bank customers.
2. B.Commercial banks, as the rate charged to their most creditworthy customers.Correct. Prime is a benchmark each bank sets for its best commercial borrowers, and it follows the Fed's policy stance.
3. C.The Board of Governors, as a ceiling on what banks are permitted to charge.Wrong. The Board sets reserve requirements and approves discount rates; it does not cap what banks may charge.
4. D.The Treasury, as part of its management of federal government borrowing costs.Wrong. The Treasury borrows money and manages federal debt, playing no part in setting bank lending rates.

Why: The prime rate is a commercial bank rate, quoted by banks for their strongest borrowers and used as a reference for many floating-rate loans. Banks move it in response to the Fed's policy stance, because the cost of the reserves funding those loans tracks the federal funds market. That relationship is why prime rises after a tightening and falls after an easing, but the decision belongs to the banks themselves. The Fed's own rates are the discount rate it charges banks and the federal funds target it steers toward.

A corporate treasurer surveys the discount rate, the federal funds rate, the broker call rate, and the prime rate. Which will she find is normally the highest, and why?

1. A.The discount rate, because the Federal Reserve is the lender of last resortLender of last resort describes the role, not a premium price. The discount rate is typically the lowest of the four.
2. B.The federal funds rate, because it is the most volatile of the fourVolatility and level are unrelated. Fed funds moves the most but generally sits near the bottom.
3. C.The prime rate, because it is a commercial lending rate that must cover credit risk and profitCorrect — the other three are wholesale or central bank rates on collateralized or very short-term funding.
4. D.The broker call rate, because margin lending is the riskiest of these activitiesCall loans are fully collateralized by marginable securities, which keeps the rate below prime.

Why: Prime is normally the highest of the four. The first three are wholesale rates on short-term, heavily collateralized or central-bank lending, while prime is an actual commercial lending rate that must cover credit risk and bank profit.