but since the fed funds rate is the banks cost of funds, why don banks simply use the fed funds rate as the index for pricing loans?
The 3 percentage points that’s tacked onto the fed funds rate exists to cover banks’ cost of making loans, costs like performing credit checks, paying loan officers to talk with customers and process the loans, paying for legal paperwork, etc. The Prime Rate is essentially the break even rate of interest for banks making loans. To make money, banks will add a margin based primarily on the risk of the loan; the higher the risk, the greater the margin.
