Commercial banks borrow from the Federal Reserve primarily to meet reserve requirements when their cash on hand is low before the close of the business day. 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 2018, the reserve requirement for banks with greater than $122.3 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.