Contributed by: Nicholas Boguth
In the spirit of preparing for season six of Game of Thrones, this set of Investor Basics and Investor Ph.D blogs is aimed to discuss bank loans and interest rates with respect to the increasingly popular adventure/fantasy television series. Check out our Director of Investment’s blog “A Game of Negative Interest Rates” HERE.
There are three types of bank loans – 1: Central Bank Loans, 2: Interbank Loans, and 3: Consumer Loans. Each loan is between different parties and has a different interest rate.
Central Banks require commercial banks to meet reserve requirements to ensure their liquidity. At the end of every day, after all of a commercial bank’s clients deposit and withdraw money, if that bank has less than the reserve requirement then it has to borrow money to raise its reserves.
If it has to borrow money to raise its reserves, it has two options. It can either borrow from the Central Bank at the discount rate, or borrow from a fellow commercial bank that has excess reserves at the end of its business day. Commercial banks borrow from each other at the federal funds rate. Currently the discount rate is 1% and the federal funds rate is 0.5%. Obviously, commercial banks prefer to borrow at the lower rate, so interbank lending is much more common than borrowing from the Central Bank. Borrowing from the Central Bank is more of a last resort for commercial banks.
The third interest rate that banks deal with is the bank lending rate. This is the rate that we, the consumers, see when we walk into a commercial bank and ask for a loan. The discount rate and federal funds rate affect banks’ lending rates, but it is also influenced by how creditworthy the customer is, the banks’ operating costs, the term of the loan, and other factors.
For all you Game of Thrones fans, you can think of the Central Bank like the Iron Bank of Braavos. It is the most powerful financial institution in the world, but it only lends to those that can repay debts (e.g. the Central Bank only lends to commercial banks). Not just anyone can borrow from the Central Bank, but the Lannister’s can because “A Lannister always pays his debts.” SPOILER ALERT coming for anyone who has not made it through season 5: Remember back to season 5 when the Iron Bank is forcing the Iron Throne to repay one-tenth of their debts? Lord Mace offers that House Tyrell could lend the Lannister’s some money so that they could meet the Iron Bank’s “reserve requirement” of one-tenth. This is interbank lending! Thankfully for us, the cost of borrowing money in real life is only the interest rate, whereas in Game of Thrones it could be one’s life.
Nicholas Boguth is an Investment Research Associate at Center for Financial Planning, Inc. and an Investment Representative with Raymond James Financial Services.
This material is being provided for information purposes only. Any opinions are those of Nick Boguth and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete.