Difference Between Fed Funds & Prime Rate

Fed fund borrowing is effectively a banks marginal cost to acquire funds. It is the cost of obtaining additional reserves to meet a banks present or expected reserve demands. When a bank is considering making additional loans to businesses or consumers and it is approaching the maximum amount it can loan out based on its existing reserves, one way of making the additional loans is by borrowing in the fed funds market from banks with excess reserves. The fed funds market is for overnight loans, when the bank is using the fed funds market to meet its added reserve demands it will have to continually borrow overnight in order to continue to meet those reserve requirements. This scenario is not uncommon and leads to a very active and liquid fed funds market. Since the fed funds rate is the incremental cost for a bank to borrow reserves in order to meet reserve requirements or make additional loans, a bank is not going to make loans at less than this rate.

In addition to the fed funds rate at which a bank may be borrowing to expand lending, there are other costs the bank will incur when it makes a consumer or business loan. Costs that will be passed on to the borrower as a spread above the funding cost of the bank and determination of risk factors. The costs may include the following: performing a credit evaluation on the borrower, paperwork, administrative costs and the cost of capital required when a bank makes new loans. It is these costs that account for and determine the spread between the fed funds and other interest rates.

The most prominent of the rates a bank will set as spread over the fed funds rate is the prime rate. The prime rate is an interest rate benchmark set by banks independently that is designed to represent the interest rate charged to their most credit worthy borrowers. Since this rate should have a low level of default risk, the rate should be fairly consistent in how it follows the fed funds rate. The magnitude of these costs determines the spread between the fed funds rate and the prime rate. In order to make a profit on additional lending activities, the banks costs must be added to the fed funds rate or the cost to acquire funds to loan out. The spread between the fed funds rate and the prime rate is generally determined by the organizational costs of a bank and its capital costs of making a loan.

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