Adjustment Credit

What Is an Adjustment Credit?

The term adjustment credit refers to a short-term loan extended by a Federal Reserve Bank to a smaller commercial bank when it needs to maintain its reserve requirements and support short-term lending. Adjustment credits are a common form of borrowing between commercial banks and Federal Reserve Banks. A commercial bank secures an adjustment credit with a promissory note, often using them when interest rates are high, and the money supply is short.

Key Takeaways

  • An adjustment credit is a short-term loan extended by a Federal Reserve Bank to a smaller commercial bank when it needs to maintain its reserve requirements.
  • Commercial banks secure adjustment credits with promissory notes when interest rates are high and the money supply is short.
  • An adjustment credit is normally extended for a very short period of time—usually overnight—and at an interest rate lower than the federal funds rate.

How Adjustment Credits Work

A commercial bank must maintain reserve requirements as set by the Federal Reserve's board of governors. Reserve requirements are considered one of the three main tools of monetary policy, along with open market operations and the discount rate. Open market operations are the purchasing and selling of securities in the open market to expand or contract the amount of money in the banking system and help control inflation. The discount rate is the interest rate charged to commercial banks for loans taken from the Federal Reserve Bank. It also serves to influence the money supply and inflation.

A commercial bank's reserve amount—held either in its own vaults or with the closest Federal Reserve Bank—reflects the total amount of deposits held on behalf of its customers. The reserve requirement assures customers that their money will always be available upon request. Reserves protect banks if customers decide to make large withdrawals en masse.

Reserve requirements protect banks if customers decide to make large withdrawals all at once.

When a bank's reserves are low, they can turn to the Federal Reserve to make up the difference through an adjustment credit. An adjustment credit is a type of short-term loan that allows a bank to continue lending to its customers. A commercial bank secures this loan by using a promissory note—a financial instrument that details a written promise by the issuer to pay the lender a definite sum of money. So by using the note, the bank promises to repay the Federal Reserve Bank the amount of money it borrows. 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 often use adjustment credits when interest rates are high and the money supply is short. Higher interest rates require larger payouts on customer deposits, while a short supply of money requires additional float to perpetuate bank operations. Adjustment credits are normally granted for very short periods of time—usually overnight. Interest rates for adjustment credits, set by the Fed, are typically lower than the federal funds rate—the rate commercial banks lend to one another.

Special Considerations

An adjustment credit is just one of the options available to commercial banks under the Federal Reserve's Regulation A, which provides guidance and rules about how institutions can borrow from the Fed's discount window. The other two options are:

  • Extended credit: This option is available when a bank can't secure a loan from another source, such as another bank. Extended credits are granted for longer periods of time than adjustment credits.
  • Seasonal credit: This type of credit is granted to smaller institutions that have a bigger need at certain periods of time of the year.