Back to: BANKING, LENDING, & CREDIT INDUSTRY
Bank Discount Rate Definition
The bank discount rate refers to the interest rate that the Central bank or Federal Reserve charges for short-term loans issued to commercial banks and financial institutions. Usually, when a bank is short funds, it can take a loan from other banks or from the Federal Reserve.
The bank discount rate is also the interest rate charged for short-term financial instruments such as Treasury bills, and commercial papers. When a change occurs in the bank discount rate charged by the Z central bank or Federal Reserve, the interest rate charged by commercial banks and other institutions in the money market would also change.
A Little More on What is a Bank Discount Rate
To calculate the bank discount rate, the formula below is applicable;
Bank Discount Rate = (Dollar Discount/Face Value) x (360/Time to Maturity)
It is important to know that the recognizable days of a year in this formula is 360 days as against the 365 or 366 days of a year. This means that the bank discount rate, when calculated, gives a lower return than the actual yield investors earn on short-term money market investments.
In investment, the bank discount rate is also used to calculate the interest that investors receive on non-coupon discount investments.
Reference for “Bank Discount Rate”
Academic research on “Bank Discount Rate”
Public Interpretation of Federal Reserve Discount Rate Changes: Evidence on the” Announcement Effect”, Waud, R. N. (1970). Public Interpretation of Federal Reserve Discount Rate Changes: Evidence on the” Announcement Effect”. Econometrica: Journal of the Econometric Society, 231-250. It is often argued that discount rate changes have a “psychological” impact on the public’s expectations about the future course of the economy; it is alleged that such changes affect economic activity by influencing the expectations of businesses, financial institutions, and other economic actors. This study attempts to assess the veracity of the notion that there is such an effect of expectations. We begin with the premise that any change in expectations about future net cash accruing to business enterprises really reflects changes in expectations about future economic conditions in general, and that changes in expectations about future cash flows will be reflected in the discounted present value of business firms and hence the market value of equity shares. After removing systematic components from such data, and analysis of the random component strongly suggests that there is an “announcement effect” on expectations associated with discount rate changes, and that there seems to be a consensus as to what the inferred information content of such changes portends for future economic conditions. Also, on days immediately preceding discount rate decreases, there seems to be come evidence of anticipation of the change.
The relation between commercial bank profit rates and banking concentration in Canada, Western Europe, and Japan, Short, B. K. (1979). The relation between commercial bank profit rates and banking concentration in Canada, Western Europe, and Japan. Journal of Banking & Finance, 3(3), 209-219. This paper examines the relation between the profit rates of 60 banks and concentration in the ‘home’ banking market of each. Other explanatory variables found to be significant are whether the bank is government owned, a proxy for profit rates throughout each country, and the rate of growth of individual banks’ assets. The evidence supports the view that greater concentration leads to higher profit rates. However the relatively small coefficients of the concentration variable indicate that relatively large changes in concentration are necessary to reduce profit rates by one percentage point.
Asymmetric information, bank lending, and implicit contracts: A stylized model of customer relationships, Sharpe, S. A. (1990). Asymmetric information, bank lending, and implicit contracts: A stylized model of customer relationships. The journal of finance, 45(4), 1069-1087. Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition thus drives banks to lend to new firms at interest rates which initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation.
Bank lending, discount window borrowing, and the endogenous money supply: a theoretical framework, Palley, T. I. (1987). Bank lending, discount window borrowing, and the endogenous money supply: a theoretical framework. Journal of Post Keynesian Economics, 10(2), 282-303.
Discount rate policy under the Classical Gold Standard: Core versus periphery (1870s–1914), Morys, M. (2013). Discount rate policy under the Classical Gold Standard: Core versus periphery (1870s–1914). Explorations in Economic History, 50(2), 205-226. Drawing on a new data set of monthly observations, this paper investigates similarities and differences in the discount rate policy of 12 European countries under the Classical Gold Standard. It asks, in particular, whether the bank rate policy followed different patterns in core and peripheral countries. Based on OLS, ordered probit and pooled estimations of central bankdiscount rate behaviour, two main findings emerge: firstly, the discount rate decisions of core countries were motivated by a desire to keep the exchange-rate within the gold points. In stark contrast, the discount rate decisions of peripheral countries reflected changes in the domestic cover ratio. The main reason for the difference in behaviour was the limited effectiveness of the discount rate tool for peripheral countries, which resulted in more frequent gold point violations. Consequently, peripheral countries relied on high reserve levels and oriented their discount rate policy towards maintaining the reserve level. Secondly, interest rate decisions were influenced by Berlin and London to a similar degree, suggesting that the European branch of the Classical Gold Standard was less London-centred than had been hitherto assumed. In establishing general patterns of discount rate policy, this paper aims to contribute to the wider discussion on monetary policy under the gold standard and the core–periphery dichotomy.