What is the prime rate?
The key interest rate is called differently in banker speech, much more complicated: It is the main refinancing facilityor also the main refinancing rate. Emphasis is placed on “refinancing” for understanding.
What is this facility for? And with that the key interest rate?
The central bank as the bank of the banks is the creator of the money in a currency area – it issues it as book money and as minted cash in the form of banknotes and coins. The banks apply for the book money, to put it quite simply. Commercial banks mostly lend not their own money when they give us, corporations or governments loans at interest. You use for it as a basis the central bank money.
The commercial banks use the key interest rate as the basis for their interest rates – i.e. the building interest, call money interest or overdraft interest.
What are the effects of low and high interest rates?
A low interest rate leads to falling interest rates, which is what we have felt in recent years. No interest on savings, low interest on mortgages. But still high interest rates on discretionary credit.
When key interest rates are high, ie when the banks themselves have to pay high interest rates to the central bank, they of course also demand higher interest rates from us. But not only in the amount of the key interest rate. Of course, the commercial banks add a further percentage, depending on who wants a loan and how reliable their solvency is. The banks also allow the risk that someone does not pay back the money they have borrowed to be repaid through interest. The riskier a loan transaction, the higher the interest rate.
The central bank in the euro zone is the ECB, for the USA the Federal Reserve Bank FED and for the pound zone the Bank of England (BoE). To name just three of the central banks that set the key interest rates in the most important currency areas.
How do banks get central bank money?
But how do the banks get the original money from the central bank, i.e. the central bank money?
By borrowing from the ECB in the euro zone, often for two weeks to a few months. On certain dates, the ECB offers the banks the money in a kind of auction. The banks write to the ECB how many billions they would like and the ECB allocates the quota of central bank money to the banks. The banks have to post collateral for this money like bonds. When the loan period is over, the banks pay back the central bank money plus the prime rate. It goes like this all the time.
So the ECB makes money by making central bank money available to the banks. The banks, in turn, base their lending on central bank money and calculate interest on installment loans, mortgage lending, overdrafts and corporate loans.
Bond purchases are terminated
The ECB has also decided not to buy any more government and corporate bonds from the euro countries from July. That’s the more important decision. The bond purchases are one of the reasons why part of the inflation has built up so strongly. Not mainly in normal consumer prices, but in asset prices for stocks and real estate.