Investors use the most recent interest rate on Treasury securities to set the benchmark minimum rate they are willing to accept on a non-government security, such as a top-rated corporate bond. The benchmark rate, also called the base interest rate, is pegged to the interest rate of the most recently-issued comparable Treasury security. Treasuries are considered risk-free because they are backed by the U.S. government. A small up-charge, called the base interest rate premium, is tacked on to reflect the added risk of a top-rated non-Treasury investment. The base interest rate is associated with the safest of non-Treasury investments. As with commercial lending, when a non-Treasury security bears an interest rate that is a great deal higher than the base interest rate, it signals that the investment is inherently riskier.
The LIBOR Benchmark
Many banks use the London Interbank Offered Rate (LIBOR) as their benchmark lending rate instead of the prime rate. The LIBOR rate is an average of rates that banks charge to lend to each other in London's money markets. In contrast, the prime rate is the benchmark rate that banks use to lend to their best customers. Since the LIBOR rate is published on a daily basis, it is volatile. The prime rate, in comparison, can remain unchanged for long periods of time. The LIBOR rate is more attractive to global bankers because it is not tied to the monetary policies of a central bank. It is determined by an international panel of banks from each participating country. The prime rate, in contrast, is tied to the monetary policies of the Federal Reserve Bank via the federal funds rate.
Significance of Benchmarks
Banks earn a profit on the spread between the cost of the funds they borrow and the loans they make. Benchmarks, be it the prime lending benchmark or the LIBOR benchmark, serve the very useful purpose of building interest rate elasticity into bank loan products. This protects banks from volatility in the cost of their borrowed funds. As the cost of bank funds change, this change is automatically passed on to the borrower.
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