The Banking System: The Federal Funds Market

The Federal Funds Market Not only do banks hold excess reserves, they also lend these excess reserves to other banks who require reserves to support loans and security purchases. Banks with excess reserves often find it convenient to loan out these reserves to other banks on an overnight basis. These loans are very safe and allow the lending bank to maintain high liquidity because the loan is repaid the following day. At the same time these loans allow the banks to earn interest on their reserves, thereby reducing the opportunity cost of holding them. When excess reserves are lent out, total reserves available to the banking system do not increase. However, the loan of excess reserves by one bank to another bank that uses the borrowed reserves to support loans to its customers acts to reduce excess reserves in the banking system by converting the excess reserves of the lending bank to required reserves of the borrowing bank. Federal funds are reserves loaned out by one bank to another bank on a short-term basis (usually overnight and rarely more than one week). Note that federal funds are neither funds belonging to the federal government nor to the Federal Reserve System. They are deposits owned by banks at the Federal Reserve banks. Any bank that maintains a deposit account at a Federal Reserve bank can either lend or borrow federal funds. Special brokers arrange loans of federal funds among banks. When a loan is made the Federal Reserve bank simply transfers deposits from the account of the lender to the account of the borrower. When the loan is repaid the borrowing bank's Federal Reserve account is debited by the amount of the loan and an amount equal to the interest on the loan. That sum is then transferred to the account of the bank that lent the funds. Most transactions in the federal funds market are very large, involving transfers of millions of dollars of reserves among banks. The federal funds rate is the interest rate charged for the loan of reserves from one bank to another. The federal funds rate is a closely watched indicator of the availability of credit in the economy. It is published daily in most financial newspapers such as The Wall Street Journal. Because the federal funds rate represents the market price of reserves to banks, its level varies with the scarcity of those reserves relative to the demand for their use to support loans. When reserves are scarce relative to demands for their use, naturally the federal funds rate rises. On the other hand when there is an increased availability of bank reserves relative to demand for their use and a consequent easing of credit conditions, the federal funds rate decreases. Because the federal funds market is very competitive, the federal funds rate fluctuates readily in response to changes in either the demand or the supply of bank reserves. Bank Portfolio Management The picture of bank deposit creation just presented is highly simplified. In actuality banking is a very complex business. Banks must be concerned with both the liquidity and the profitability of their operations. Banks earn profits because they can make loans at higher interest rates than the rates they pay to attract deposits. In fact, for most checkable deposit accounts, banks pay no interest to depositors. They also charge fees for checking services and other financial services. For time deposit accounts, such as savings accounts and certificates of deposit, banks pay interest to compete with other financial intermediaries and attract deposits. A bank whose management makes loans only to the least creditworthy applicants is likely to be able to charge higher interest rates than if it made safer loans. The bank can make higher profits provided the customers actually do repay their loans. However, the bank risks the possibility that a high percentage of its loans will default. Loan default means the bank will not earn any interest and will also lose the funds it has lent out. The bank must balance its desire for increased profitability against the risk of default and the risk of having assets that cannot be easily converted to reserves to meet unexpected withdrawals. To do so, most bankers are careful to have a diversified portfolio, or mix, of assets. Typically a bank will make some risky loans at high interest rates. The riskiest types of loans are those that are simply unsecured promises to repay. Consumer loans, such as those on credit card accounts, are an example of this type of risky loan. Banks also make short-term loans to creditworthy businesses at lower interest rates than they charge consumers. The prime rate is the interest rate a bank charges its most creditworthy customers, usually large corporations, for short-term loans of less than one year. A bank often demands collateral, which is an asset a borrower pledges to a lender in case of default. For example, if you borrow money to buy a car, the bank typically asks you to pledge the car as collateral. The bank usually has a formal lien on the car, which means you can't sell the car without the bank's permission or repayment of the loan. If you default on the loan, the bank can seize the car and sell it to obtain the outstanding balance on your loan. Similarly, a mortgage is a loan a bank makes to finance the purchase of a house or other real estate, with the loan secured by that asset as collateral. The interest rate a bank charges on a loan depends on the collateral offered by the customer, the customer's credit history (as rated by independent credit bureaus), and various other factors. In general, loans are not very liquid. Most loans cannot be easily called in to be converted to reserves when the need arises. However, very short-term loans, those made for a period of, say, one to three months, turn over quickly and give the bank some flexibility in adjusting the amount of loans outstanding when the need for reserves arises. The business of banking involves careful portfolio management to balance risks, profits, and liquidity. Most banks carry 10 percent to 20 percent of their assets in the form of government securities that can be sold quickly at very low transaction costs to obtain reserves when the bank needs them. Government securities are interest-bearing debts of the federal government in the form of Treasury bills, Treasury notes, and Treasury bonds. The interest earned on these securities is typically lower than the interest the bank can earn on loans. However, their liquidity is worth the loss in profitability to the bank.