Key Difference – Bank Rate vs Base Rate
Knowledge regarding bank rate and base rate is important for both borrowers and lenders in order to understand how these rates are affected by various economic conditions and government policies. The key difference between bank rate and base rate is that the bank rate is the rate at which the central bank in the country lends money to commercial banks, while base rate is the rate at which the commercial banks lend funds to the public in the form of loans.
CONTENTS
1. Overview and Key Difference
2. What is Bank Rate?
3. What is Base Rate?
4. Side by Side Comparison – Bank Rate vs Base Rate
5. Summary
What is Bank Rate
Bank rate is also referred to as the ‘discount rate’ and is the rate at which the central bank lends funds to the commercial banks. The commercial banks have a minimum reserve amount of funds to maintain and when the bank reaches this minimal threshold level, they borrow from the central bank. This is usually done in the form of short-term loans. Determining the bank rate is usually done quarterly to control the money supply in the economy.
The Central bank is responsible for maintaining the financial stability of an economy. The money supply in the economy is controlled by the central bank using two ways, which are interrelated.
Fiscal Policy
These are the government policies to influence the macroeconomic conditions such as to control unemployment, inflation and exchange rates within an economy.
Monetary Policy
Monetary policy includes actions taken to manage the money supply and interest rate (rate applied for borrowing and saving) within the economy.
E.g. If the inflation rates are increasing in the economy and the government desires to control it, a higher interest rate can be offered to the public as an incentive to save more. As a result, the money supply in the economy will reduce.
What is Base Rate
The base rate is the rate at which commercial banks grant loans to the public. The Base rate should not be below the Bank rate. Banks operate as an intermediary, accepting deposits from savers and lending funds to borrowers. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers and recorded as the ‘Net Interest Margin’ (NIM).
Factors Affecting the Base Rate
Economic Conditions
Economic conditions in a country are subjected to changes over time with favourable and unfavourable paces. In an economic recession (reduction in economic activity in a country) where the consumer confidence is low commercial banks will offer loans at a lower rate with the intention of increasing consumer spending. When the economy starts recovering and the customers are engaging in more spending the banks will begin to increase the interest rates gradually.
Nature of the Yield Curve
Banks continuously attempt to grow their net income. The relationship between short term and long term interest rates is an important factor to consider by banks since they can earn higher profits if the short-term interest rates are lower than the average long-term interest rates. This relationship is depicted in a ‘yield curve’ which is a graphical representation of fixed interest security plotted against the length of time.
Customers
Banks also consider factors specific to the customers for whom they grant loans; the rate at which the banks lend to individual customers may also differ based on credit worthiness of the customers. If the respective customer has a high credit worthiness and a long-term relationship with the bank, such customers are likely to receive loans at a favourable rate compared to less creditworthy customers.
Figure_1: Difference Between Bank Rate and Base Rate
What is the difference between Bank Rate and Base Rate?
Bank Rate vs Base Rate |
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| The bank rate is the rate at which government lends funds to commercial banks. | The base rate is the rate at which commercial banks lend funds to the public. |
| Rate Specification | |
| Rate offered may change from one commercial bank to another. | Rate offered may change from one customer to another. |
Summary – Bank Rate vs Base Rank
In conclusion, the key difference between bank rate and base rate lies on the financial institution that decides and offers the said rate. Bank rate is decided by the central bank of an economy to control the money supply. Base rate is the rate at which commercial banks lend funds to the public and this is heavily dependent on prevailing market conditions.
Reference:
“Bank Rate.” Investopedia. N.p., 21 Aug. 2015. Web. 05 Feb. 2017.
Fontinelle, Amy. “Fiscal Policy.” Investopedia. N.p., 30 Dec. 2015. Web. 05 Feb. 2017.
“How a Recession Can Affect Personal Loan Rates.” How a Recession Can Affect Personal Loan Rates – Financial Web. N.p., n.d. Web. 05 Feb. 2017.
Fuhrmann, CFA Ryan C. “How Banks Set Interest Rates on Your Loans.” Investopedia. N.p., 22 June 2016. Web. 06 Feb. 2017.
DePersio, Greg. “Why do commercial banks borrow from the Federal Reserve?” Investopedia. N.p., 28 July 2015. Web. 06 Feb. 2017.