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Benchmark Lending Rate Versus the Prime Interest Rate

In essence, the benchmark lending rate can be described as the interest rate that the bank has to pay when the institution borrows money from another bank or large corporation. The benchmark rate is to be distinguished from the prime rate of the banks, as the latter expresses the minimum and individual interest rate settled by the bank and on top of which the institution places additional charges based on the level of risk of the borrower. The benchmark rate is typically used by banks to determine the realistic prime lending rate (PLR) that they should charge and it helps calculate other rates of interest.

In order to understand the meaning of the benchmark lending rate, let's imagine a bank in the U.S. The PLR and American bank sets is usually in accordance with the federal funds rate, established by the Federal Reserve. The Federal Reserve is an institution with the power to influence the money supply via open market transactions. Consequentially, the banks that calculate their PLR using the federal funds rate will have to charge major borrowers an interest rate that was calculated in accordance to the Federal Reserve's set rate. In a nutshell, the importance of the prime rate is that it is the decisive factor regarding the interest rates borrowers can receive money.

So, how are the benchmark rates actually used in the lending process? For starters, any changes in the federal funds rate will directly affect the abilities of the banks to make cash transfers, as they need to watch out on ensuring they have the right amounts in their reserves. Therefore, when the federal funds rate increases, then all interest rates on loans provided to consumers and the return rate on the bank's deposit certificates, such as money market accounts, certificates of deposit and savings accounts will stagnate or decrease slightly.

In general, there are two methods used to calculate the prime lending rates. The first method, which is rather rarely used, implies that the prime rates and the benchmark lending rates are established by the authorities that manage the rates. The second one is commonly used in most countries of the world and it is based on the market forces. In short, the market forces imply the growth or contraction of the economy, trade balances, money supplies of the national banks, macroeconomic factors and so on.

It is important to note that there is some controversy regarding the way the Federal Reserve sets its prime rate and hence, influences the PLR of the other banks in the U.S. Basically, the federal funds rate is an exception and rarely set of rules used by the Federal Reserve to intentionally affect the economy.

By manipulating the cash flow, usually by increasing the supply in the open trade markets, they are assuming some huge risks, according to some economists. This main disadvantage of the expansionary monetary policy is that it is prone to add deficits and increase the inflation in the economy. According to the critics of the policy, the economy will stabilize and the benchmarks will emerge naturally, despite the financial crises U.S. and other countries are facing today.