Ask Dr. Econ

What is the cause of the spread between the federal funds rate and the prime lending rate? (03/1999)

Think of fed funds borrowing as banks' marginal cost of funds. In other words, if a bank is considering making a $1 million loan to a business, one way of funding the loan is by borrowing in the fed funds market from banks with excess reserves. (Since the fed funds market is for overnight loans, to fund the business loan, which for most loans, is for longer maturity than overnight, the bank will have to repeatedly borrow overnight. But this is not unusual.) With the current fed funds rate at 4.75 %, the bank is certainly not going to lend at less than this rate to the business borrower. Plus, on top of this there are several other costs the bank must bear when it makes a business loan, costs which must therefore be passed on to the borrower as a spread above this 4.75 % funding cost. It is these costs that account for, and determine the spread between the fed funds and prime rates.

The costs include the following: the costs of doing a credit evaluation on the business, of sending out a loan officer to talk to the borrower, and of performing the legal paperwork to make the loan. Additionally, the bank faces another cost: it is required by regulation to raise 8 cents of capital for every $1.00 in loans it makes. With a 15 percent average return on equity, equity capital is not cheap. The bottom line is that all of these costs must be added on top of the bank's minimum cost of funds, the fed funds rate, to determine how much the bank must charge the business borrower in order to break even on the loan. The magnitude of these costs determines the spread between the fed funds rate (i.e. the interest rate at which the bank borrows) and the prime rate (the interest rate the bank charges to make a business loan).

So do we know what the sum of all these costs is? Well one estimate is the average interest spread for U.S. banks. In other words the difference between what banks paid for funding and what they charged borrowers. According to the June 1998 Board of Governors of the Federal Reserve Bulletin (p. 413), this amounted to about 3.20 % (8.14 % average interest income less 4.92 % average interest cost) in 1997. So if we add 3.20 % to the 4.75 % we come up with our estimate of what the average bank should charge the average business borrower at 7.95 %. With a current prime rate at 8.00 % now this sounds about right.

Bottom line: The spread between the fed funds rate and the prime rate is a function of banks' administrative and capital costs of making a business loan.

For Further Reading

Furlong, Fred. 1991. "Is the Prime Rate Too High?" FRBSF Weekly Letter 91-25 (July 5).

Laderman, Elizabeth. 1990. "The Changing Role of the Prime Rate." FRBSF Weekly Letter (July 13).


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