A:

Commercial banks borrow from the Federal Reserve primarily to meet reserve requirements when their cash on hand is low before the close of business. To put itself back over the minimum reserve threshold, a bank borrows money from the government's central bank utilizing what is known as the discount window. Borrowing at the discount window is convenient because it is always available and the lending process includes no negotiation or extensive documentation. The downside, however, is the discount rate, or the interest rate at which the Federal Reserve lends to banks, is higher than if borrowing from another bank.

Reserve Requirements Explained

Prior to the 1930s, the government imposed no regulations on banks as to the amount of cash they had to keep on hand relative to their deposit liabilities. Following the stock market crash of 1929, depositors, fearful of bank collapses, arrived in masses to withdraw their money. This caused many banks to become insolvent, as the amounts requested in withdrawals exceeded the cash they had on hand.

The government responded by implementing reserve requirements that forced banks to keep a percentage of their total deposit liabilities on hand as cash. As of 2015, the reserve requirement for banks with greater than $103.6 million in deposits is 10%.

Utilizing the Federal Reserve

Occasionally, robust lending activity depletes a commercial bank's cash reserves to where they fall below the government's mandated reserve requirement. At this point, the bank has two options to avoid running afoul of the law. It can borrow from another bank, or it can borrow from the Federal Reserve.

Borrowing from another bank is the cheaper option, but many commercial banks, especially when only taking out an overnight loan to meet reserve requirements, elect to borrow from the discount window because of its simplicity.

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. How are bank reserve requirements determined and how does this affect shareholders?

    Learn how bank reserve requirements are determined and how bank reserves affect shareholders through improved bank stability ... Read Answer >>
  3. What happens if the Federal Reserve lowers the reserve ratio?

    Learn about the Federal Reserve's monetary policy and the tools it uses to control it. Understand what happens if the Federal ... Read Answer >>
  4. Who determines the reserve ratio?

    Understand what the Federal Reserve is and what it regulates in the U.S. economy. Learn about the reserve ratio and how the ... Read Answer >>
  5. How is money supply used in monetary policy?

    Learn about the three components of the Federal Reserve's monetary policy. Understand how these three components use the ... Read Answer >>
  6. What does a large multiplier effect signify?

    Find out more about the multiplier effect, what it measures and what a large multiplier effect indicates about an economy. Read Answer >>
Related Articles
  1. Personal Finance

    What is Fractional Reserve Banking?

    Fractional reserve banking is the banking system most countries use today.
  2. Insights

    Government Policies to Control Inflation

    Inflation occurs when an economy grows due to increased spending.
  3. Personal Finance

    Fed's Discount Rate

    The Federal discount rate is the amount of interest a central bank charges private banks for short-term loans.
  4. Insights

    The Role of Commercial Banks in the Economy

    We interact with commercial banks daily to carry out simple financial tasks. That said, the function and creation of a commercial bank is anything but simple.
  5. Trading

    How The Federal Reserve Manages Money Supply

    The Fed's three main tools are manipulating reserve requirements, changing the discount rate, and open-market operations.
  6. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
RELATED TERMS
  1. Reserve Ratio

    The portion (expressed as a percent) of depositors' balances ...
  2. Federal Reserve Credit

    Refers to the process of the Federal Reserve lending funds on ...
  3. Bank Reserve

    Bank reserves are the currency deposits which are not lent out ...
  4. Working Reserves

    Reserves held by banks above the required minimum level - or ...
  5. Bank Rate

    The interest rate at which a nation's central bank lends money ...
  6. Commercial Bank

    A commercial bank is a type of financial institution that accepts ...
Hot Definitions
  1. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  2. Absolute Advantage

    The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost ...
  3. Nonce

    Nonce is a number added to a hashed block, that, when rehashed, meets the difficulty level restrictions.
  4. Coupon

    The annual interest rate paid on a bond, expressed as a percentage of the face value. It is also referred to as the "coupon ...
  5. Socially Responsible Investment - SRI

    Socially responsible investing looks for investments that are considered socially conscious because of the nature of the ...
  6. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. ...
Trading Center