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  Dear
Dr. Don,
Why is the prime rate always set 3 percent above the federal funds
rate since the early '90s, whereas before, the spread tended to
be much lower and fluctuating. Was it some kind of institutional
change?
-- Karel Credit-Cartel
 Dear
Karel,
A lot of the change had to do with marketing
efforts by banks. The prime rate was the short-term interest rate
that banks charged their best, or prime, customers. Telling a prospective
business account customer that it didn't qualify for the bank's
prime rate might cause the bank to lose the account to another lender
that would lend to them at their prime rate.
Loan officers, rather than tell second-tier creditors
that they couldn't borrow at the prime rate, grossed up the prime
rate and lent to the bank's best customers at interest rate below
the prime rate. When you start lending to your best customers at
rates below the prime rate, the term loses some of its meaning.
The rate is still important as an interest rate benchmark, but banks
now make loans at a range of interest rates above and below the
prime rate. For example, I've seen home equity lines of credit marketed
at prime less 0.25 percent.
Bankrate tracks the prime
rate as reported by The Wall Street Journal. The Journal surveys
the 30 largest banks, and when at least 75 percent of them change
rates, the Journal changes its rate, effective on the day the Journal
publishes the new rate. It's the most widely quoted measure of the
prime rate.
The lock-step relationship you observe between the
federal funds rate and the prime rate makes sense. If you consider
the targeted fed funds rate as a bank's wholesale cost of money,
loans made based on that cost of funds have to be grossed up to
compensate the bank for the lending risk and to provide a profit
margin. If the prime rate didn't closely track the fed funds rate,
that would mean that the lending spreads were contracting and expanding
based on market conditions.
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