Effect of Discount Rate on Bank Interest Rates

Discount Rates and Their Influence on Bank Decisions

Discount rates are special interest charges imposed by Federal Reserve Banks (Fed) on short-term loans made by financial institutions, particularly depository banks. The Federal Reserve’s discount rate indicates the current worth of prospective cash flow (Grey, 2002, p.32). Discount rates are calculated by taking into account both the risks of uncertain future cash flows and the time value of money. A high risk likelihood attracts a high discount rate. This paper explores how discount rates influence bank decisions when determining specific interest rates, as well as the differences between the Federal Reserve System and Japan’s monetary system. The high discount rate charged by Federal Reserve forces banks and other depository institutions to raise their interest rates (Thornton, 1986, p. 6). The effect is caused by a change in the cost of borrowing money which is transferred from the Federal Reserve to commercial banks. Financial institutions, especially commercial banks are usually skeptical when they set interest rates for their customers. The amounts that the banks charge to their clients on borrowing are determined by legislative and economic factors including the ease of obtaining money from the Federal Reserve (Grey, 2002, p.32).

Influence of Discount Rates on Lending Decisions

The financial institutions set interest rates that reflects cost they incur while borrowing funds from the Fed. When banks find it easy to borrow money from the Federal Reserve, they tend to lower their subsequent rates charged to customers (Thornton, 1986, p. 7). However, other economic conditions such as the market interest rates and regulations by commercial, legislative bodies influence the decisions by banks on subsequent amounts that they charge to their customers. Even though there is no direct relationship between discount and interest rates, it is evident that the borrowing cost of money from the Federal Reserve influences the decisions by banks on their lending charges. However, there is a need for strict regulations to ensure that depository institutions do not take advantage of the decisions by the Federal Reserve and shift their burden to borrowers.

Federal Reserve System vs. Monetary System in Japan (Bank of Japan)

The Federal Reserve System (Fed) and the Bank of Japan have many similarities. They are independent of political influence, they pursue multiple objectives, and are all centralized. However, these two systems also differ in many avenues. First, the Fed act as a central bank of the United States while Bank of Japan is the central bank of Japan. The monetary objective of Fed is to promote maximum employment, stable prices and moderate long-term interest rate while that of the Bank of Japan is to ensure price and financial system stability (Mongelli et al. 200, p.14).

Besides, the Fed pursues Risk management approach as its monetary policy strategy while Bank of Japan monetary policy strategy involves information content of a variety of economic indicators. Furthermore, the monetary policy decision-making body of Japan monetary system comprises of nine members while that of Fed consists of 12 members (Mongelli et al. 200, p.14). The Federal Reserve System Board meets eight times a year whereas the monetary policy board of Bank of Japan meets once or twice every month. These banks monetary system also differs in that the Fed can print money at its will without consulting the government. This right was granted to it by the Congress. However, Bank of Japan can only print money under the authority of Japan government.

References

Grey, G. B. (2002). Federal reserve system: Background, analyses, and bibliography. Huntington, NY: Nova Science Publ. Retrieved from https://books.google.com/books?id=8W2LEYUC_LkC&pg=PA159&lpg=PA159&dq=Federal+Reserve+System:+Background,+analyses,+and+bibliography.&source=bl&ots=jjFZi5zHNh&sig=Nv7jOuBJ_9YAZMuRp2Saeb73Exk&hl=en&sa=X&redir_esc=y#v=oepage&q=Federal%20Reserve%20System%3A%20Background%2C%20analyses%2C%20and%20bibliography.&f=false

Thornton, D. L. (1986). The discount rate and market interest rates: Theory and evidence. Federal Reserve Bank of St. Louis Review, 68(7), 5-21. Retrieved from https://pdfs.semanticscholar.org/419d/d6bc24fd178b0838fe222dc380921e6a6868.pdf

Mongelli, F. P., Gerdesmeier, D., & Roffia, B. (2009). The Fed, the Eurosystem, and the Bank of Japan: More similarities or differences? Retrieved from

http://voxeu.org/article/fed-eurosystem-and-bank-japan-similarities-and-differences