Commercial banks borrow from the Federal Reserve System (FRS) primarily to meet reserve requirements before the end of the business day when their cash on hand is low. Borrowing from the Fed allows banks to get themselves 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 via the discount window is convenient because it’s always available. The process includes no negotiation or extensive documentation. The downside, however, is the discount rate—the interest rate at which the Federal Reserve lends to banks—is higher than if borrowing from another bank.
- Banks can borrow from the Fed to meet reserve requirements.
- These loans are available via the discount window and are always available.
- The rate charged to banks is the discount rate, which is usually higher than the rate that banks charge each other.
- Banks can borrow from each other to meet reserve requirements, which is charged at the federal funds rate.
Banks Must Meet Reserve Requirements
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. The previous reserve requirement was 10%, but as of March 26, 2020, the reserve requirement was moved to 0%.
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.
Banks Can Borrow From Other Banks
But banks can opt to pay a higher interest rate and borrow from another bank. The rate that banks charge each other is known as the federal funds rate. Although this rate is typically 50 basis points below the discount rate, as of April 2020 the two are equal—at 0.25%.
Loans from banks to each other are also done on an overnight basis. Banks use their excess reserve balances to lend to other banks. The Federal Open Market Committee (FOMC) meets eight times a year to set the federal funds rate. The committee sets a target for the rate, although banks don’t have to charge the exact rate. The rate charged is negotiated between the two banks.