Adjustment credit is a short-term loan, which a Federal Reserve Bank extends to a smaller commercial bank when the commercial bank needs to maintain its reserve requirements and support short-term lending. These advances are a ubiquitous form of borrowing between commercial banks and a Federal Reserve Bank. A commercial bank most often uses them when interest rates are high, and the money supply is short.
Breaking Down Adjustment Credit
Commercial banks must hold a certain amount of funds in reserve to assure customers that their money will always be available upon request. When reserves are low, adjustment credits allow banks to continue to lend through advances via the Federal Reserve. The commercial bank will secure these advances through its promissory notes.
A promissory note is a financial instrument, detailing a written promise by the creator or issuer of the note's to pay another party (the note's payee) a definite sum of money. Payment can be specified either on-demand or at a set future date and typically contains all the terms pertaining to the indebtedness, such as the principal amount, interest rate, maturity date and place of issuance, and issuer's signature.
As noted above, commercial banks more often use adjustment credits when interest rates are high, and the money supply is short. High-interest rates require larger payouts on customer deposits; a short supply of money requires additional float to perpetuate bank operations.
Adjustment Credit and Updated Reserve Requirements Standards
The Fed's board of governors sets the reserve requirements, which they deem to be one of the three main tools of monetary policy — the other two tools being open market operations and the discount rate. Open market operations (OMO) are the purchasing and selling of government securities in the open market to expand or contract the amount of money in the banking system; while the discount rates helps control for inflation.
The Fed mandates that a bank’s reserve funds be held in the bank's vaults or at the closest Federal Reserve bank. If, in contrast with a shortage of funds and the need for an adjustment credit to meet standards, a bank has excess reserves, it’s possible the institution could receive interest on them, according to The Financial Services Regulatory Relief Act of 2006. This rate of interest is referred to as the interest rate on excess reserves and serves as a proxy for the federal funds rate.