Commercial banks borrow from the Federal Reserve System (FRS) to meet reserve requirements or to address a temporary funding problem. The Fed provides loans through the discount window with a discount rate, the interest rate that applies when the Federal Reserve lends to banks. This rate is commonly higher than the federal funds rate commercial banks charge each other when providing immediate overnight liquidity.
Key Takeaways
- Banks can borrow at the discount rate from the Federal Reserve to meet reserve requirements.
- Loan programs are available to financial institutions via the discount window.
- The Fed charges banks the discount rate, commonly higher than the rate that banks charge each other.
- Banks can borrow from each other at the federal funds rate.
Reserve Requirements
Before the 1930s, banks were not required to hold a specified amount of cash in reserve relative to their deposit liabilities. Following the stock market crash of 1929, fearful depositors converged to withdraw their money. Many banks became insolvent as the withdrawals exceeded the available cash.
Reserve requirements were introduced to force banks to keep a percentage of their total deposit liabilities as cash. Reserves are held in the vault in the financial institution or at the closestFederal Reserve bank.The reserve requirement traditionally stood at 10% but was revised to 0% in 2020 by the Fed's Board of Governors and eliminated all depository requirements.
Borrowing From the Federal Reserve
Lending activity or a temporary funding crisis can deplete a commercial bank's cash reserves and leave it unable to support deposits. A bank can borrow from the Federal Reserve through the discount window, which helps commercial banks manage short-term liquidity needs. Banks unable to borrow from other banks in the federal funds market may borrow directly from the central bank's discount window and pay thediscount rate.
The Federal Reserve banks offer three discount window programs to depository institutions. Primary credit is available for banks in stable financial conditions.Secondary credit is for depository institutions that do not qualify for primary credit. Seasonal credit helps small depository institutions to manage significant swings in their loans and deposits.
Borrowing From Other Banks
Banks can opt to borrow from other banks. The rate that banks charge each other is known as the federal funds rate. This rate is typically 50 basis points below the discount rate and set by theFederal Open Market Committee (FOMC). Commercial banks borrow and lend their excess reserves to each other overnight using this rate. The Federal Open Market Committee (FOMC) meets eight times a year to set the federal funds rate.
Historical Lending Rates
| Discount Rate vs. Federal Funds Rate | ||
|---|---|---|
| Date | Discount Rate | Federal Funds Rate |
| May 2023 | 5.25% | 4.83% |
| March 2018 | 2.25% | 1.69% |
| December 2008 | 0.5% | 0.16% |
Why Does the Federal Reserve Lend Money to Financial Institutions?
The Federal Reserve lends to depository institutions to assist with temporary funding issues.
There may be unexpected changes in a bank's loans and deposits or an extraordinary event, such as the financial crisis of 2008 and 2009. The Fed provides loans when market funding cannot meet a bank's funding needs.
What Are Excess Reserves?
Excess reserves are capital reserves held by a bank or financial institution more than what is required by regulators, creditors, orinternal controls.These reserves are also called secondary reserves.
How Often Does the Federal Funds Rate Change?
The Federal Open Market Committee (FOMC) sets a target federal funds rate eight times a year, which depends on prevailing economic conditions.
The Bottom Line
The Federal Reserve offers banks three discount window loan programs for temporary liquidity assistance. Banks can borrow at the discount rate from the Federal Reserve to meet their reserve requirements.The discount rate is commonly higher than the rate banks charge each other, the federal funds rate.
Correction—May 4, 2023: A previous version of this article misstated that the federal funds rate, the rate charged by banks to other banks, is higher than the discount rate provided by the Federal Reserve.
Article Sources
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Board of Governors of the Federal Reserve System. "The Discount Window and Discount Rate."
Board of Governors of the Federal Reserve System. "Reserve Requirements."
The Federal Reserve. "Discount Window."
Board of Governors of the Federal Reserve System. "About the FOMC."
Board of Governors of the Federal Reserve System. "Why Does the Federal Reserve Lend Money to Banks?"
