Consumers who try to beat the financial system by studying rules devised by banks may be missing the bigger picture, the one that bankers try to see and anticipate. Many consumers suspect, for example, that bank policies hinge on inflation rates, but they are not always clear why that is.
The story starts with the U.S. Federal Reserve, which is the federal bank that commercial banks go to when they need to borrow or when they need to tuck away money short term.
The Federal Reserve policy makers at 10 meetings per year set the federal fund rate, which is the interest rate they charge banks for loans. And their thinking is predicated on two mandates from Congress. The Fed in equal measures is mandated to manipulate policies to keep inflation within the range of 2 percent (just under that is considered ideal) and to maximize employment.
As such, the Federal Reserve seeks to influence lending: A lower rate is considered a liberal policy, because cheaper borrowing, in theory, allows businesses to borrow for expansion. In theory (again), expanded businesses generally means more hiring will take place.
However, prices sometimes have a mind of their own, which is to say no matter what lawmakers attempt to do in Washington, D.C., outside influences also affect prices. An outbreak of violence in the Middle East drives up the price of oil, for example, as suppliers fear their stocks could diminish.
Supply and demand is still the backbone of pricing, but you might say inflation is also the product of opportunism. Businesses, in other words, raise prices as high as the marketplace can stand. Supply and demand accounts for a lot, but prices for the same item are higher in wealthy neighborhoods than they are in poor ones, not because of infrastructure, but because of a willingness for the consumer to pay more – because of opportunity. This is also why prices for gas are higher on the interstate than in local gas stations. As travelers are stuck on an Interstate, prices go up, because the opportunity is there.
How all this affects credit card policy is simple enough: Banks carve out their place in the market to attract customers and keep their shareholders happy.
This brings up the antidote for opportunistic pricing and that is called competition. Rival businesses drive prices down, because lower prices is a great way to attract customers.
Now back to that credit card: Credit cards with no balance transfer fees is the sign of a healthy rivalry between lenders, because the opportunity here favors the consumer. Bank rivals do what they can to put flashy deals in front of potential customers and stack the benefits they can offer near the start of their relationships with them.
Banks also offer adjustable rate loans based on a variety of indexes, often using what is called the London inter-bank offering rate (the Libor) which is an index set by British finance regulators and is supposed to be the average lending rate commercial banks offer to each other.
A bank does not always borrow from their country's central bank, like the Federal Reserve. They also borrow from each other. Banks then report to the authorities their average borrowing rate involving other commercial banks. The average rate from these reports is published and lenders all over the globe use that rate, the Libor, to determine rates for loans they create for customers.
An adjustable rate, for example, might be set up as the Libor rate plus 1 percent.
If the Libor goes up, so do the rates on adjustable rate loans. If it is a fixed-rate loan, the Libor also serves as a starting point for that.
Written by Jane Brown
