The Federal Reserve impacts a bank's profitability with its influence on interest rates and the money supply. The discount rate and the federal funds rate are two benchmark rates that most interest rates in the banking industry follow in some way. Lending activities become constricted when these rates are high, as banks find it expensive to obtain capital by borrowing from the Federal Reserve or from other banks. The Federal Reserve can grow or shrink the money supply by purchasing or selling U.S. Treasury bonds on the open market. These activities also affect a bank's profitability. A robust money supply equates to more money to lend and earn interest on, while a shrinking money supply curtails a bank's moneymaking activities.

The Federal Reserve requires banks to keep a minimum amount of cash on hand at all times. This amount is based on the bank's total deposits. The requirement exists to prevent bank runs, which were common in the wake of the stock market crash of 1929 and nearly brought down the entire U.S. economy. A bank run happens when customers request more money in withdrawals than the bank has available to give. The more cash a bank is required to keep on hand, the lower the chance of a bank run if turmoil in the markets spooks customers into withdrawing their money.

When a bank lends so much money during the business day that its cash on hand drops below the Fed's requirement, it has two options to cover the shortfall. It can borrow money directly from the Fed at the discount window, or it can borrow from another bank. The discount rate, over which the Fed has full autonomy, is charged when borrowing from the Fed. The federal funds rate, which the Fed can influence heavily but not set unilaterally, is the prevailing market rate charged by other banks.

By taking action to raise both rates, the Fed makes it more expensive for banks to borrow money to cover reserve shortfalls. In response, banks curtail lending activities to ensure their cash on hand remains sufficient. Reduced lending activities result in reduced profits; interest from loans is the primary way banks make money. Conversely, a low discount rate and a low federal funds rate encourage lending; banks can deplete their reserves and borrow enough to meet minimum requirements inexpensively.

Similarly, the Fed has the ability to grow or constrict the money supply through bond sales or purchases. This activity affects profitability in the banking industry by varying the amount of money available for banks to lend to businesses and individual consumers. A reduced money supply means less money to lend, which translates to lower profits for banks. An increased money supply increases lending and, as a result, a bank's profits.

  1. What are the implications of a high Federal Funds Rate?

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  2. Why do commercial banks borrow from the Federal Reserve?

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  3. How is money supply used in monetary policy?

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  4. How do central banks inject money into the economy?

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  5. What's the difference between the prime rate and the discount rate?

    Learn more about the prime rate and the discount rate and how the Federal Reserve uses these rates in the U.S. economy. Explore ... Read Answer >>
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