A:

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.

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

    Learn the implications of a high federal funds rate, which include constriction of the money supply, a stronger dollar and ... Read Answer >>
  2. Why do commercial banks borrow from the Federal Reserve?

    Learn how commercial banks borrow from the Federal Reserve to meet minimum reserve requirements, and discover the pros and ... Read Answer >>
  3. What are the most important interest rates?

    Learn about the most important interest rates in the economy; the Federal funds rate and discount rate are set by the Federal ... Read Answer >>
  4. Three Major Facts How Central Banks Influenced Money Supply

    Central banks use several different methods to increase (or decrease) the amount of money in the banking system. Learn three ... Read Answer >>
  5. What economic indicators are important to consider when investing in the banking ...

    Find out which economic indicators are most useful for investors in the banking sector, especially those influenced by central ... Read Answer >>
  6. What are the implications of a low Federal Funds Rate?

    Find out what a low federal funds rate means for the economy. Discover the effects of monetary policy and how it can impact ... Read Answer >>
Related Articles
  1. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  2. Insights

    The Federal Reserve System Affects You More Than You Might Think

    How does the Federal Reserve System affect ordinary citizens? In more ways than you might realize.
  3. Investing

    How Do Interest Rates Affect the Stock Market?

    Interest rates can have a complicated ripple effect through financial markets. Here's what you need to know.
  4. Insights

    Understanding How the Federal Reserve Creates Money

    Read about how the Federal Reserve actually targets and creates new money in the economy, and find out why the savings and loans system magnifies this process.
  5. Personal Finance

    Retail Banking vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking refers to the aspect of banking that deals with corporate customers. Check out more on the differences between ...
RELATED TERMS
  1. Federal Discount Rate

    The interest rate set by the Federal Reserve that is offered ...
  2. Net Free Reserves

    A statistic released in weekly Federal Reserve data showing the ...
  3. Adjustment Credit

    Adjustment credit is a short-term loan, which a Federal Reserve ...
  4. Net Borrowed Reserves

    A statistic released in weekly Federal Reserve data showing the ...
  5. Federal Funds

    Federal funds are excess reserves that commercial banks deposit ...
  6. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository ...
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center