![]() Cost of Equity: This method determines the rate at which capital will return to shareholders who have invested in the business.Cost of Debt: This method estimates what a business will need to return to creditors on debt, and will fluctuate with current interest rates.Weighted Average Cost of Capital: This comprehensive method utilizes the cost of equity, the cost of debt, the business’ equity and debt, and the corporate tax rate.Raising the rate can help reduce inflation when the economy is growing, and lowering it can help create growth when times are tough. By changing the discount rate, the Federal Reserve can encourage banks to be more aggressive or conservative in their lending. It’s also a powerful tool used to protect the economy as a whole. ![]() However, the discount rate isn’t just used to keep banks in good regulatory standing. If the bank is unable to borrow money from another bank or raise money by selling assets such as government bonds, then it can make use of the discount window to cover the reserve requirement. If banks have too little money on hand to cover their reserve ratio, then they can be subject to fines. Those with more than $127.5M must keep at least 10% in reserve. ![]() Banks with more than $16.9M and up to $127.5M must hold 3%of their total liabilities in reserve. Banks with $16.9M or less in assets don’t have to hold any money in reserve. The amount of money banks must possess at the end of a business day in relation to their assets is known as the reserve ratio. The money kept on hand ensures that the people who deposited money at the bank will be able to withdraw it when they need it. However, banks are required to maintain a minimum amount of money on hand at the end of the day. Unlike the other two discount rates, seasonal discount rates vary with market conditions.īanks make money in part by loaning out their deposits through mortgages, personal loans, and other types of loans. However, loans made at the seasonal discount rate can offer up to nine months for repayment. Consequently, banks must prove that a seasonal pattern is responsible for swings in liquidity to receive a loan. ![]() Farmers and students are groups likely to take out a lot of loans at similar times in the year, which can dramatically reduce a bank’s reserve cash. As the name implies, these loans compensate for seasonal lending activity. The Federal Reserve generally provides these loans to small banks and credit unions that serve a community. Because the loans are riskier, the Federal Reserve generally charges half a percentage point more interest on these loans than they do on primary credit loans.įinally, there is a seasonal discount rate. Banks with ongoing financial issues qualify for this tier. The second tier is the secondary credit rate. Banks that have a good financial record qualify for these loans, which carry the lowest interest rates. The program as a whole is known as the “discount window,” which consists of three separate tiers. In most situations, the banks only need the loans for a day or less, and they pay many of these loans back in less than 24 hours. The most common use of the term discount rate is to refer to the interest rate the Federal Reserve charges on short-term loans it makes to banks.
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