Why Do Commercial Banks Borrow From the Federal Reserve?

Commercial banks borrow from the Federal Reserve System (FRS) to meet temporary liquidity requirements. The Fed provides loans to member banks through its discount window using what is called the discount rate.

Key Takeaways

• Banks can borrow at the discount rate from the Federal Reserve when they require more capital to meet immediate withdrawal requirements or other liquidity issues.
• The Fed charges banks the discount rate, which is used as the ceiling for its target rate range.
• The Federal Reserve encourages banks to borrow from and lend to each other, rather than from the discount window.

Borrowing From the Federal Reserve

Lending activity or a temporary liquidity crisis can deplete a commercial bank’s cash reserves and leave it unable to support withdrawals. When a bank is in this state, it can borrow from another bank at a rate that falls somewhere in between the Federal Reserve’s target rate range.

If a bank fails to find a lender to support its overnight needs, it can borrow from the Federal Reserve at what the Fed calls its discount window.

The discount window is assigned a rate by the Federal Open Market Committee, which uses the discount window rate (called the discount rate) as the ceiling (top number) for the Fed’s target rate range. This rate is used when setting the target rate range to encourage banks to borrow from each other, because they will charge each other less than the Fed will.

Note

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.

To borrow from the Fed’s discount window, institutions are required to offer up (pledge) collateral such as loans or securities. Some types of collateral that banks can pledge are:

• Electronic Consumer Loans
• Commercial Loans
• Credit Card Receivables
• U.S. Treasury Bills/Notes/Bonds
• Corporate Bonds
• Certificates of Deposit
• Commercial Paper
• Trust Preferred Securities

Borrowing From Other Banks 

Banks can opt to borrow from other banks (preferred by the Fed). However, they may not always find a lender. In 2020, the Fed switched from a regime of abundant reserves (required) to one of ample reserves (optional), where it pays interest on the reserve balances held by banks with the Fed. This rate, called Interest on Reserve Balances (IORB), is the Fed’s primary tool for manipulating the rate banks charge each other for overnight loans.

The rates that banks charge each other are weighted and averaged by the Fed each day and published as the Effective Federal Funds Rate (EFFR).

Important

The Federal Funds Rate used to be set by the Fed prior to 2020, but it is now the weighted average calculated by the Fed (the EFFR). However, it is still referred to as the FFR.

Thus, the process of deciding rates and which entity to borrow from looks like this:

• The Fed sets the discount and ON RRP rates (the target rate range)
• The Fed sets and updates the IORB rate
• Banks borrow from each other at rates they determine within the rate range
• The EFFR is calculated and published
• Banks use the EFFR and IORB to determine the rates on their loans to other banks. They may decide to loan to banks, or to leave funds in reserve, whichever pays them the most interest
• If the EFFR falls below the IORB rate, banks might choose to deposit funds at the ON RPP facility to earn interest instead of lending to other banks or keeping funds in reserve

Historical Lending Rates

Sources: Federal Reserve Bank of St, Louis, Federal Reserve Bank of New York

Explain Bank Borrowing Like I’m 5

Banks lend customer deposits and earn interest on these loans. So, there may be occasions when a bank doesn’t have enough cash to support a withdrawal. At that time, it will need to find funds from another bank.

Banks consider other banks customers, and can lend them funds overnight, charging interest to banks just like they would a consumer. At times, it might be the only option for a bank to borrow funds from the Federal Reserve. The Fed charges higher interest rates on its loans to encourage banks to borrow from each other, and creates a range of interest rates from banks to use when they lend to other banks.

This interest rate range is what you might hear about being updated by the Fed in its latest Federal Open Market Committee statement. These statements publish the latest rate ranges eight times per year, and are used to stablize the economy and encourge bank to bank lending.

Do Banks Borrow From the Federal Reserve?

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 Is Overnight Bank Borrowing From the Federal Reserve Called?

Overnight bank borrowing from the Fed is called Overnight Bank Funding, and this activity is measured by the Overnight Bank Funding Rate (OBFR). The OBFR indicates the cost of funding for U.S.-based banks, calculated using Fed funds and Euro dollar transactions. It’s important to note that the OBFR is not the weighted average of rates banks charge each other overnight (the EFFR).

Is My Social Security Number a Federal Reserve Bank Account?

No. Your Social Security number is your Social Security identifier, used to track earnings and determine your retire ment benefits from the Social Security Administration.

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 any liquidity requirements if they cannot find another bank to borrow from.