<p>Loans in the federal funds market are also nicknamed 'overnight loans.' This means they cannot use that money to make loans because the money gets returned as soon as the bank's reserves are cleared by the Fed. </p>

<p>If the lending bank was willing to use the money for an asset such as a loan, they would simply loan it to a consumer at the higher rate. There is no way that a bank would loan to another bank for any long period of time because, as you pointed out, they can get a higher rate of return by loaning it elsewhere. Typically, the banks that are lending in the federal funds market are banks who have decided to hold excess reserves for one reason or another. If the bank was looking to loan the money for a period of time, they would have already done so outside of the federal funds market.</p>

<p>Also, if the federal funds rate was higher than the nominal interest rate, banks would not go to the federal funds market to get a loan (because they can get one for cheaper in the public market), which would make the existence of a federal funds market pointless.</p>

CC BY-SA 3.0
2015-11-22T18:54:33.310Z
I agree with the first two paragraphs. I disagree your claim in the third paragraph. Banks need reserve to satisfy the deposit reserve ratio, so they either need to decrease deposit or increase reserve. If the requirement is 0.1, i.e. reserve/deposit>0.1. Borrowing 1 unit from the Fed funds market increase the numerator and borrowing from the public means a decrease in their demand depsoit (because by borrowing we mean deposit becomes loans on bank's liability account) decrease the denominator. Simple algebra means borrowing one unit reserve from fed funds and one unit from public is different
Kun
CC BY-SA 3.0
2015-11-22T18:59:28.293Z
You are misunderstanding what I said. I am not saying that the bank would be borrowing from the public (against their deposits). I am saying that the bank would borrow from another bank at the nominal rate (because it's lower). It is the exact same transfer as borrowing in the federal funds market.
DornerA
CC BY-SA 3.0
2015-11-22T20:01:34.293Z
Well, directly borrowing from other banks is the definition of fed funds market (if you mean transfers of reserve) . Fed funds market is not operated by the Fed, only the discount window is.
Kun
CC BY-SA 3.0
2015-11-22T20:05:10.790Z
Ok, if that is your hangup think of it this way. Suppose banks can only borrow in the federal funds market. Also, suppose the federal funds rate is higher than the nominal rate of interest. Banks would simply forgo lending past their reserve requirement because their rate of return would be lower than the rate they need to pay to borrow the money, so no trading would occur in the federal funds market. Therefore, the federal funds market would serve no purpose.
DornerA
CC BY-SA 3.0
2015-11-22T20:44:35.513Z
Okay. So you still did not get my point. I am saying 1 unit of fed funds support 10 unit of borrowing. So even if fed funds is say 2 percent, you would still be lending 1 percent if there is perfect demand and no risk . This is beacuse with 1 unit reserve, you are now lending 10 unit, which earns you ten times 1 percent, which is 10 percent.
Kun
CC BY-SA 3.0
2015-11-22T20:54:13.967Z
Suppose bank A is the borrowing bank and bank B is the lending bank. Of course bank A would want to borrow because of what you stated above. However, bank B would not lend the funds to them for a long enough period of time for bank B to turn around and lend it in the public market. If bank A was looking to lend the funds, they would do so in the public market in order to make more interest. If this arbitrage of sorts you are speaking of could happen, every bank would be demanding funds in the federal funds market and no banks would be supplying them.
DornerA
CC BY-SA 3.0
2015-11-22T22:09:57.013Z
What you just said is correct. But still, theoretically banks can always roll over overnight loans, just like overnight repos.
Kun
CC BY-SA 3.0
2015-11-22T22:21:26.647Z
Theoretically, this can happen. However, if banks did this, lending banks would cease trusting the borrowing banks and, as happened in my previous example, supply drops to zero.
DornerA
CC BY-SA 3.0
2015-11-22T15:11:18.690Z
2015-11-22T15:11:18.690Z
DornerA
<p>The core premise of your question is correct.  Banks receive a tremendous advantage from Fed actions and any discerning economist should be concerned over the amount of corporate welfare doled out banks....especially as they will take that money and engage in maturity mismatching which is an incredibly volatile, dangerous and inflationary practice that transfers wealth from the public to the private banking sector.</p>

<p>There are many such ways banks receive corporate welfare.  This includes Fed dividends (for not loaning out 100% of our deposits!). It also includes interest on "excess reserves" (again our deposits).  Troubled banks are given below market interest rates with discount window loans.  But the bigger problem with the discount window is that it creates a certainty that the Fed will backstop bad behavior.  Then there is the open market.  The Fed overpays for REPO's from special banks (primary dealers).  There is also a good reason to suggest the REPO market is being churned as well to encourage excess trading volume.  But the big problem with the open market is it provides artificial liquidity guarantees to the banking system at large.  If banks know that the Fed will ensure that the money market will hum along at a very low rate, then they are more apt to engage in maturity mismatching which creates inflation and volatility.  The entire system is corrupt beyond belief and most economists are totally oblivious to this reality.</p>

CC BY-SA 3.0
2015-12-02T01:12:47.787Z
Hi. This answer seems to mostly be opinion (and or rhetoric). Your answer would be greatly improved if you are able to back these statements up with any facts or possibly a model.
cc7768
CC BY-SA 3.0
2015-12-02T01:29:05.773Z
The question is not a math one.  It's one of policy.  You can not understand central banking without understanding the political philisophy behind its actions.  It is an illusion to keep separate economics from politics and any attempt to do so will result in confusion.
user2662680
CC BY-SA 3.0
2015-12-02T01:40:08.167Z
I didn't ask specifically for mathematical facts (it happens that I find models and numbers to be convincing but I understand people find different types of arguments to be useful). As is, your answer is a series of unbacked assertions. It would greatly benefit from a reference to any type of research (economic or political science based -- a newspaper article might even be better than nothing). Although I believe you and I disagree about this topic, a well informed answer I disagree with can still be a high quality answer.
cc7768
CC BY-SA 3.0
2015-12-02T02:50:08.973Z
A mathematical framework is worthless without proper conceptual context. eg I can mathematically calculate how fast a ball will drop using physics, but if I don't have the right variables/context (like wind resistance), my formula is worthless.  This is a conceptual/political paradigm  so political answers are apt. As for a references, this is a circular demand.  A statement can not not be validated by another.  To imply otherwise is to advocate dogma and mob logic.  If you have specific questions, I would be happy to answer them.
user2662680
CC BY-SA 3.0
2015-12-02T23:25:47.590Z
What @cc7768 is saying is that if you are going to make assertions, back them up. Don't respond by saying maths without the right assumptions is worthless, back up your own claims with evidence.
Jamzy
CC BY-SA 3.0
2015-12-04T23:02:51.397Z
Math may be useless without context, but you can't just imagine a context that isn't there. Math is part of what we use to verify whether our understanding matches what is happening.
Kitsune Cavalry
CC BY-SA 3.0
2015-12-02T00:07:10.003Z
2015-12-02T00:07:10.003Z
user2662680
<p>I think you are missing the credit risk attached to any loan. You, as an individual borrower, are far more likely not to reimburse your loan than a bank. Thus the loan is far less risky.</p>

<p>Central bank money could only be qualified as "better" (even that does not mean much) because it is issued by the Central bank, deposits are issued by commercial bank, so you bear the risk that your bank fail, but it happens that in most country individual deposits are insured by some state agency. So I cannot really see why central bank money would be better than deposits.</p>

<p>Nowadays, the amount of reserves that a bank must hold does not actually play a big role in the economy (as opposed to what most of economic textbooks and economic professors are teaching in undergrad schools). The most important part is the interest rate that is paid on those reserve, which is fixed by the central bank and which act as an opportunity cost for the bank when it decides to lend to an individual rather than holding reserves.</p>

<p>However I see your point, but the fact is that this way of thinking is misleading. Banks create (in theory) as many loans as they want, because there are no physical constraints, if you want, that prevent them to do so. The only constraint is a regulatory constraint that states that in order to remain solvent (in order to be able to repay the depositors) banks should invest x% of the assets in reserves. Those reserves would be held on a central bank account in central bank money, and the return on those reserves will be the fed fund rate decided by the central bank (the same way a commercial bank decide how much interest it will pay on your savings account). So it is true that one more unit of reserves gives the right to issue more than one unit of loans but this does not mean that one money is better or worse than another. It's is just a matter of regulation.</p>

<p>It may be hard to get, but the point is really that central bank money is safer so cheaper than deposits, no matter what regulatory constraints apply to banks.</p>

<p>You may want to read this <a href="http://web.stanford.edu/~kumhof/banks-lf-fmc.pdf" rel="nofollow">paper</a> which may be a bit complicated but you should get the intuition. This two docs may be simpler (with nice pictures) : <a href="http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneyintro.pdf" rel="nofollow">doc 1</a>, <a href="http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf" rel="nofollow">doc 2</a>.</p>

CC BY-SA 3.0
2015-11-21T20:34:29.163Z
I take your point about the cedit risk. But fractional reserve means with 1 unit of reserve, the banks can generate 10 units more loans hypotetically, right? Even accounted for credit risk and possible transfer of the deposit issues to other banks, which will cost reserve, the reserve money's interst rate should be higher. In other words, reserve money is better than deposit because 1 unit of reserve can support 10 units of deposit (loans). And hence 1 unit of reserve earns 10 times the interest a 1 unit deposit could earn. Do you see my point?
Kun
CC BY-SA 3.0
2015-11-21T21:00:53.947Z
First, fractional banking generating 10 units of loans for 1 units of reserves would work only when a) money supply is not fixed by the central bank and b) the bank in question is the only bank in the economy..
ChinG
CC BY-SA 3.0
2015-11-21T21:25:14.887Z
@ChinG What do you mean by money supply is not fixed by the central bank? In this argument, let us assum central bank fix monetary base. Moreover, the bank in question is certainly not the only bank, otherwise there is no borrowing in fed funds market.
Kun
CC BY-SA 3.0
2015-11-21T22:37:25.670Z
@Kun I just edited my answer, does that sound clearer?
Louis. B
CC BY-SA 3.0
2015-11-21T22:45:25.660Z
@Louis. B I think the paper you suggested answers just what I am wondering. I will take some time reading it and hopefully I will learn something! Thank you very much.
Kun
CC BY-SA 3.0
2015-11-21T22:53:39.303Z
@Kun you're welcome, hope it'll help. Cheers
Louis. B
CC BY-SA 3.0
2015-11-21T23:05:09.090Z
@ Louis. B May I ask anotehr question? For U.S. banks eurodollars and fed funds borrowing are close substitutes in satisfying the reserve requirement. But it seems to me that fed funds is better in a sense that fed funds increase reserve directly while for eurodollar borrowing, all you might have is a decrease in deposit (due to the foreign bank) and a increase in eurodollar borrowing in its liability, if the foreign bank deposits dollar at that US bank. Although in some cases it might involve a increase in reserve if the foreign bank hold its dollar deposit at another bank.
Kun
CC BY-SA 3.0
2015-11-21T23:20:49.110Z
@Kun, are you sure that from a regulatory perspective Eurodollars deposits are similar to Fed reserves? And btw, a bank make reserves by *lending* to the central bank right, the same way you lend money to your bank when you increase your deposits. I can't see why eurodollar deposits would decrease the banks deposits? I'm not so familiar with the US money market, I don't want to guess something, I don't know. To me it would just add some counterparty risk form the bank that would hold those eurodollar deposits...
Louis. B
CC BY-SA 3.0
2015-11-21T23:31:01.603Z
It is said that just like US banks keep their base money with the Fed, Eurodollar banks keep their base with the US banks as deposit. In other words, Eurodollar banks settle their payment using their deposit at the US banks. A section on eurodollar in the following paper explains it. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_review/1992/pdf/er780501.pdf
Kun
CC BY-SA 3.0
2015-11-21T23:42:52.820Z
Ok I'll have a look, but I guess this could be an old practice. I mean, at least since the crisis and the increasing concern on bank's default, I found hard to believe that this works the same way as decades ago.
Louis. B
CC BY-SA 3.0
2015-11-21T23:59:44.073Z
@Louis.B The Fed Funds market is not collateralized.
dismalscience
CC BY-SA 3.0
2015-11-22T00:11:00.160Z
@dismalscience Tks for noting, I didn't know that it was different form the European central bank market in which the ECB uses repo for its open market operation. The idea remains correct, right? I'll edit the answer.
Louis. B
CC BY-SA 3.0
2015-11-22T00:46:27.440Z
@Louis.B The Fed uses repo for open market operations as well, but that is separate from the Fed Funds market.
dismalscience
CC BY-SA 3.0
2015-11-22T03:23:55.857Z
@dismalscience Okay tks. I'm gonna read more about that.
Louis. B
CC BY-SA 3.0
2015-12-02T00:18:59.177Z
@Louis.B You made the remark that the amount of reserves a bank holds is not consequential.  Modern banking can cheat reserve requirements (somewhat) by inducing the Fed to inject more reserves into the banking system.  The tail does wag the dog.  If the banks can't create as much in deposits at they want, they induce the Fed to create more reserves.  Very dishonest.  Now reserve requirements are still important...just depends on the bank and their credit rating.  For some capital requirements are the bottleneck.  Some cheat the system by switching to higher unregulated aggregates.
user2662680
CC BY-SA 3.0
2015-11-21T20:01:48.057Z
2015-11-22T00:12:21.987Z
2015-11-22T00:12:21.987Z
Louis. B
<p>First of all, fed funds rate is the rate banks borrow reserves' from each other. Interest rate on loans is the rate the bank charges to public for its loan. From one line of logic, we think of the rate bank charges to public should clearly be greater than the interest rate itself bear to borrow since banks are making a margin. And empirical data clearly support it.</p>

<p>However, another line of logic does not quite support it. We know the banks borrow reserve money in fed funds market, which is clearly better than the money it lends to the public in the following sense: one unit of fed funds can support 10 units of additional deposit if the reserve-deposit ratio is 10%. So the banks with this addtional 1 unit of reserve, can theoretically make 10 more units of loans and therefore creating 10 more units of deposit. So reserve is better money. Hence, theoreticaly, the fed funds rate should at leastbe higher than the rate banks make loans to the public, if not 10 folds.</p>

<p>My question being whether there is a logical fallacy in my understanding and if not, what kind of reality deviated it from theory.</p>

CC BY-SA 3.0
2015-11-21T17:40:16.957Z
I know saying banks creating money is going to raise rage from a wide range of people, even economists. But anyway, this is the truth.
Kun
CC BY-SA 3.0
2015-11-23T17:51:32.407Z
One thing that you need to change in this question is that you seem to have a fundamental misunderstanding of how the money multiplier works. It is not that a bank receives 1 and can loan out 10. It is actually that a when a bank gets 1 they can only loan out 0.90 (with a reserve requirement of 10%). This fundamental misunderstanding is what lead you to believe that there would be an incentive for banks to drive the federal funds rate above the nominal rate on interest. I would recommend you watch the following video: https://www.youtube.com/watch?v=lMpmwcSMQTw
DornerA
CC BY-SA 3.0
2015-11-24T14:26:12.530Z
I recommend you reading this essay published by the Bank of England. http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf
Kun
CC BY-SA 3.0
2015-12-02T00:10:59.010Z
@DornerA Kun's understanding is actually correct.  The exact nitty gritty transaction details are inconsequential to the basic concept at large which is that more reserves do allow for the creation for more bank deposits because of the money multiplier.  Banks do not directly influence the Fed to inject more reserves into their coffers, but their indirect actions do.
user2662680
CC BY-SA 3.0
2015-12-02T00:25:26.023Z
@user2662680 you are not arguing the same point as he is. You said that more reserves lead to banks (PLURAL) creating more deposits. His misunderstanding comes when he says that a bank (SINGULAR) that gets 1 dollar can instantly loan out 10. The money multiplier works because the money travels through many (in theory infinitely many) banks.
DornerA
CC BY-SA 3.0
2015-12-02T01:34:31.010Z
@DornerA I think that is an artificial distinction.  It is implied that the poster knows what he is referring to.  That a bank must hold at least 10% of their demand deposits on hold is the same conceptually as the banking system in the aggregate multiplying reserves 10 fold to create further demand deposits.
user2662680
CC BY-SA 3.0
2015-12-02T01:42:07.810Z
@user2662680 his whole argument hinges on the fact that one bank could get a loan for a dollar and loan out 10 dollars. Suppose he uses the correct understanding of the money multiplier and suppose the federal funds rate is higher than the nominal rate (as he states it should logically be). What incentive would the bank have to take the loan in the federal funds market in the first place? Suppose the nominal rate is 1% and the fed funds rate is 2%. The bank would be paying 20 dollars interest on a 1000 dollar loan when they can only make at most 9 dollars with a 10% requirement.
DornerA
CC BY-SA 3.0
2015-12-07T00:00:11.017Z
@DornerA First of all, the textbook multiplier is wrong in its mechanics about how money is created but somewhat right in its result. Moreover, thought the bank will be paying 20 dollars on 1000 dollars loan, I argue he can lend 10000 dollars. This satsitfies the 10% requirement because 1000dollar/10000dollar = 10%.
Kun
CC BY-SA 3.0
2015-12-07T00:06:14.227Z
How can they lend 10,000 dollars? They must keep 10% as reserves, so the bank can only lend 900 if they receive a 1,000 loan. This is exactly what I am talking about. Your misunderstanding of the money multiplier comes when you think that the money multiplier being 10 means that a single bank can loan 10 times what they borrow. The money multiplier comes from the money moving through MULTIPLE (in theory, infinitely many) banks. A bank cannot get an extra 1,000 in deposits and then loan out 10,000 because then they have less reserves and more deposits
DornerA
CC BY-SA 3.0
2015-12-07T04:39:01.083Z
@DornerA In practice, no money needs to be moved for the money to "multiply." The regulation is 10 percent. So the bank can simply put 10000 dollars in borrower's checking account and keeping the 1000 the bank has. This fits perfectly well with regulation. This process can be thought as a swap of IOU. The bank is issuing a deposit, which says I will pay you cash or other bank's deposit on demand. And the borrower is creating a loan, in which he says I will pay the bank in some speficit future date.
Kun
CC BY-SA 3.0
2015-12-07T04:39:29.200Z
@DornerA I think it will help you better see my argument if you read the link to a BoE essay I suggested above.
Kun
CC BY-SA 3.0
2015-12-07T04:51:37.527Z
@Kun there's one problem I have. Where does this 10,000 that the bank can put into the borrowers account come from? If it comes from deposits then they no longer meet the reserve requirement. If they must liquidate other assets to get the funds then what is the point of making the loan?
DornerA
CC BY-SA 3.0
2015-12-07T20:09:34.113Z
@DonerA This is where we need to define what we mean by money. Moeny, in the old days, are mainly gold and silver. Nowadays, deposit in thebank accouts are also considered money. Since deposit is a bank's liability, theoretically without the reserve requirment, the bank can issue unlimited amount of deposit to fund their loans just like I issue a IOU, as long as people are willing to take it. It may sounds crazy that banks can create deposit, and hence meony. However, note that banks' ability to issue deposits is bounded because sometimes people want to windraw cash.
Kun
CC BY-SA 3.0
2015-12-07T20:11:07.507Z
@DornerA And sometimes people wish to transfer their deposit to anotehr bank, say Bank B. If so, the bank will need to pay bank B with his reserve at the Fed, which is not created by the banks but only the Fed.
Kun
CC BY-SA 3.0
2015-12-08T01:39:02.363Z
If a bank decides to 'issue deposits' they are then obligated to hold 10% of it in reserves since the reserve requirement is a percentage of deposits that must be held by banks. Since the bank cannot simply issue an IOU to the Fed, they must liquidate assets to meet the reserve requirement. This begs the question of why would a bank liquidate assets making the nominal rate in order to find another asset to make the same interest rate?
DornerA
CC BY-SA 3.0
2015-12-08T15:42:00.940Z
Why would the bank need to liquidate assets? I thought we are considering the case where the bank is taking a fed funds loan.
Kun
<banking>
Why isn't the Fed funds rate greater than interest rate on loans to the pubic
Kun
# Why isn't the Fed funds rate greater than interest rate on loans to the pubic

(Asked by: username_0 on 2015-11-21)

First of all, fed funds rate is the rate banks borrow reserves' from each other. Interest rate on loans is the rate the bank charges to public for its loan. From one line of logic, we think of the rate bank charges to public should clearly be greater than the interest rate itself bear to borrow since banks are making a margin. And empirical data clearly support it.

However, another line of logic does not quite support it. We know the banks borrow reserve money in fed funds market, which is clearly better than the money it lends to the public in the following sense: one unit of fed funds can support 10 units of additional deposit if the reserve-deposit ratio is 10%. So the banks with this addtional 1 unit of reserve, can theoretically make 10 more units of loans and therefore creating 10 more units of deposit. So reserve is better money. Hence, theoreticaly, the fed funds rate should at leastbe higher than the rate banks make loans to the public, if not 10 folds.

My question being whether there is a logical fallacy in my understanding and if not, what kind of reality deviated it from theory.

**Tags:** banking
> **Comments:**
> **username_0**: I know saying banks creating money is going to raise rage from a wide range of people, even economists. But anyway, this is the truth.  
> **username_1**: One thing that you need to change in this question is that you seem to have a fundamental misunderstanding of how the money multiplier works. It is not that a bank receives 1 and can loan out 10. It is actually that a when a bank gets 1 they can only loan out 0.90 (with a reserve requirement of 10%). This fundamental misunderstanding is what lead you to believe that there would be an incentive for banks to drive the federal funds rate above the nominal rate on interest. I would recommend you watch the following video: https://www.youtube.com/watch?v=lMpmwcSMQTw  
> **username_0**: I recommend you reading this essay published by the Bank of England. http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf  
> **username_2**: @DornerA Kun's understanding is actually correct.  The exact nitty gritty transaction details are inconsequential to the basic concept at large which is that more reserves do allow for the creation for more bank deposits because of the money multiplier.  Banks do not directly influence the Fed to inject more reserves into their coffers, but their indirect actions do.  
> **username_1**: @user2662680 you are not arguing the same point as he is. You said that more reserves lead to banks (PLURAL) creating more deposits. His misunderstanding comes when he says that a bank (SINGULAR) that gets 1 dollar can instantly loan out 10. The money multiplier works because the money travels through many (in theory infinitely many) banks.  
> **username_2**: @DornerA I think that is an artificial distinction.  It is implied that the poster knows what he is referring to.  That a bank must hold at least 10% of their demand deposits on hold is the same conceptually as the banking system in the aggregate multiplying reserves 10 fold to create further demand deposits.  
> **username_1**: @user2662680 his whole argument hinges on the fact that one bank could get a loan for a dollar and loan out 10 dollars. Suppose he uses the correct understanding of the money multiplier and suppose the federal funds rate is higher than the nominal rate (as he states it should logically be). What incentive would the bank have to take the loan in the federal funds market in the first place? Suppose the nominal rate is 1% and the fed funds rate is 2%. The bank would be paying 20 dollars interest on a 1000 dollar loan when they can only make at most 9 dollars with a 10% requirement.  
> **username_0**: @DornerA First of all, the textbook multiplier is wrong in its mechanics about how money is created but somewhat right in its result. Moreover, thought the bank will be paying 20 dollars on 1000 dollars loan, I argue he can lend 10000 dollars. This satsitfies the 10% requirement because 1000dollar/10000dollar = 10%.  
> **username_1**: How can they lend 10,000 dollars? They must keep 10% as reserves, so the bank can only lend 900 if they receive a 1,000 loan. This is exactly what I am talking about. Your misunderstanding of the money multiplier comes when you think that the money multiplier being 10 means that a single bank can loan 10 times what they borrow. The money multiplier comes from the money moving through MULTIPLE (in theory, infinitely many) banks. A bank cannot get an extra 1,000 in deposits and then loan out 10,000 because then they have less reserves and more deposits  
> **username_0**: @DornerA In practice, no money needs to be moved for the money to "multiply." The regulation is 10 percent. So the bank can simply put 10000 dollars in borrower's checking account and keeping the 1000 the bank has. This fits perfectly well with regulation. This process can be thought as a swap of IOU. The bank is issuing a deposit, which says I will pay you cash or other bank's deposit on demand. And the borrower is creating a loan, in which he says I will pay the bank in some speficit future date.  
> **username_0**: @DornerA I think it will help you better see my argument if you read the link to a BoE essay I suggested above.  
> **username_1**: @Kun there's one problem I have. Where does this 10,000 that the bank can put into the borrowers account come from? If it comes from deposits then they no longer meet the reserve requirement. If they must liquidate other assets to get the funds then what is the point of making the loan?  
> **username_0**: @DonerA This is where we need to define what we mean by money. Moeny, in the old days, are mainly gold and silver. Nowadays, deposit in thebank accouts are also considered money. Since deposit is a bank's liability, theoretically without the reserve requirment, the bank can issue unlimited amount of deposit to fund their loans just like I issue a IOU, as long as people are willing to take it. It may sounds crazy that banks can create deposit, and hence meony. However, note that banks' ability to issue deposits is bounded because sometimes people want to windraw cash.  
> **username_0**: @DornerA And sometimes people wish to transfer their deposit to anotehr bank, say Bank B. If so, the bank will need to pay bank B with his reserve at the Fed, which is not created by the banks but only the Fed.  
> **username_1**: If a bank decides to 'issue deposits' they are then obligated to hold 10% of it in reserves since the reserve requirement is a percentage of deposits that must be held by banks. Since the bank cannot simply issue an IOU to the Fed, they must liquidate assets to meet the reserve requirement. This begs the question of why would a bank liquidate assets making the nominal rate in order to find another asset to make the same interest rate?  
> **username_0**: Why would the bank need to liquidate assets? I thought we are considering the case where the bank is taking a fed funds loan.  

---

## 3 answers

### Answer by username_6 on 2015-11-21. Score: 4 | Accepted answer

I think you are missing the credit risk attached to any loan. You, as an individual borrower, are far more likely not to reimburse your loan than a bank. Thus the loan is far less risky.

Central bank money could only be qualified as "better" (even that does not mean much) because it is issued by the Central bank, deposits are issued by commercial bank, so you bear the risk that your bank fail, but it happens that in most country individual deposits are insured by some state agency. So I cannot really see why central bank money would be better than deposits.

Nowadays, the amount of reserves that a bank must hold does not actually play a big role in the economy (as opposed to what most of economic textbooks and economic professors are teaching in undergrad schools). The most important part is the interest rate that is paid on those reserve, which is fixed by the central bank and which act as an opportunity cost for the bank when it decides to lend to an individual rather than holding reserves.

However I see your point, but the fact is that this way of thinking is misleading. Banks create (in theory) as many loans as they want, because there are no physical constraints, if you want, that prevent them to do so. The only constraint is a regulatory constraint that states that in order to remain solvent (in order to be able to repay the depositors) banks should invest x% of the assets in reserves. Those reserves would be held on a central bank account in central bank money, and the return on those reserves will be the fed fund rate decided by the central bank (the same way a commercial bank decide how much interest it will pay on your savings account). So it is true that one more unit of reserves gives the right to issue more than one unit of loans but this does not mean that one money is better or worse than another. It's is just a matter of regulation.

It may be hard to get, but the point is really that central bank money is safer so cheaper than deposits, no matter what regulatory constraints apply to banks.

You may want to read this [paper](http://web.stanford.edu/~kumhof/banks-lf-fmc.pdf) which may be a bit complicated but you should get the intuition. This two docs may be simpler (with nice pictures) : [doc 1](http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneyintro.pdf), [doc 2](http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf).

> **Comments:**
> **username_0**: I take your point about the cedit risk. But fractional reserve means with 1 unit of reserve, the banks can generate 10 units more loans hypotetically, right? Even accounted for credit risk and possible transfer of the deposit issues to other banks, which will cost reserve, the reserve money's interst rate should be higher. In other words, reserve money is better than deposit because 1 unit of reserve can support 10 units of deposit (loans). And hence 1 unit of reserve earns 10 times the interest a 1 unit deposit could earn. Do you see my point?  
> **username_7**: First, fractional banking generating 10 units of loans for 1 units of reserves would work only when a) money supply is not fixed by the central bank and b) the bank in question is the only bank in the economy..  
> **username_0**: @ChinG What do you mean by money supply is not fixed by the central bank? In this argument, let us assum central bank fix monetary base. Moreover, the bank in question is certainly not the only bank, otherwise there is no borrowing in fed funds market.  
> **username_6**: @Kun I just edited my answer, does that sound clearer?  
> **username_0**: @Louis. B I think the paper you suggested answers just what I am wondering. I will take some time reading it and hopefully I will learn something! Thank you very much.  
> **username_6**: @Kun you're welcome, hope it'll help. Cheers  
> **username_0**: @ Louis. B May I ask anotehr question? For U.S. banks eurodollars and fed funds borrowing are close substitutes in satisfying the reserve requirement. But it seems to me that fed funds is better in a sense that fed funds increase reserve directly while for eurodollar borrowing, all you might have is a decrease in deposit (due to the foreign bank) and a increase in eurodollar borrowing in its liability, if the foreign bank deposits dollar at that US bank. Although in some cases it might involve a increase in reserve if the foreign bank hold its dollar deposit at another bank.  
> **username_6**: @Kun, are you sure that from a regulatory perspective Eurodollars deposits are similar to Fed reserves? And btw, a bank make reserves by *lending* to the central bank right, the same way you lend money to your bank when you increase your deposits. I can't see why eurodollar deposits would decrease the banks deposits? I'm not so familiar with the US money market, I don't want to guess something, I don't know. To me it would just add some counterparty risk form the bank that would hold those eurodollar deposits...  
> **username_0**: It is said that just like US banks keep their base money with the Fed, Eurodollar banks keep their base with the US banks as deposit. In other words, Eurodollar banks settle their payment using their deposit at the US banks. A section on eurodollar in the following paper explains it. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_review/1992/pdf/er780501.pdf  
> **username_6**: Ok I'll have a look, but I guess this could be an old practice. I mean, at least since the crisis and the increasing concern on bank's default, I found hard to believe that this works the same way as decades ago.  
> **username_8**: @Louis.B The Fed Funds market is not collateralized.  
> **username_6**: @dismalscience Tks for noting, I didn't know that it was different form the European central bank market in which the ECB uses repo for its open market operation. The idea remains correct, right? I'll edit the answer.  
> **username_8**: @Louis.B The Fed uses repo for open market operations as well, but that is separate from the Fed Funds market.  
> **username_6**: @dismalscience Okay tks. I'm gonna read more about that.  
> **username_2**: @Louis.B You made the remark that the amount of reserves a bank holds is not consequential.  Modern banking can cheat reserve requirements (somewhat) by inducing the Fed to inject more reserves into the banking system.  The tail does wag the dog.  If the banks can't create as much in deposits at they want, they induce the Fed to create more reserves.  Very dishonest.  Now reserve requirements are still important...just depends on the bank and their credit rating.  For some capital requirements are the bottleneck.  Some cheat the system by switching to higher unregulated aggregates.  

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### Answer by username_1 on 2015-11-22. Score: 2

Loans in the federal funds market are also nicknamed 'overnight loans.' This means they cannot use that money to make loans because the money gets returned as soon as the bank's reserves are cleared by the Fed.

If the lending bank was willing to use the money for an asset such as a loan, they would simply loan it to a consumer at the higher rate. There is no way that a bank would loan to another bank for any long period of time because, as you pointed out, they can get a higher rate of return by loaning it elsewhere. Typically, the banks that are lending in the federal funds market are banks who have decided to hold excess reserves for one reason or another. If the bank was looking to loan the money for a period of time, they would have already done so outside of the federal funds market.

Also, if the federal funds rate was higher than the nominal interest rate, banks would not go to the federal funds market to get a loan (because they can get one for cheaper in the public market), which would make the existence of a federal funds market pointless.

> **Comments:**
> **username_0**: I agree with the first two paragraphs. I disagree your claim in the third paragraph. Banks need reserve to satisfy the deposit reserve ratio, so they either need to decrease deposit or increase reserve. If the requirement is 0.1, i.e. reserve/deposit>0.1. Borrowing 1 unit from the Fed funds market increase the numerator and borrowing from the public means a decrease in their demand depsoit (because by borrowing we mean deposit becomes loans on bank's liability account) decrease the denominator. Simple algebra means borrowing one unit reserve from fed funds and one unit from public is different  
> **username_1**: You are misunderstanding what I said. I am not saying that the bank would be borrowing from the public (against their deposits). I am saying that the bank would borrow from another bank at the nominal rate (because it's lower). It is the exact same transfer as borrowing in the federal funds market.  
> **username_0**: Well, directly borrowing from other banks is the definition of fed funds market (if you mean transfers of reserve) . Fed funds market is not operated by the Fed, only the discount window is.  
> **username_1**: Ok, if that is your hangup think of it this way. Suppose banks can only borrow in the federal funds market. Also, suppose the federal funds rate is higher than the nominal rate of interest. Banks would simply forgo lending past their reserve requirement because their rate of return would be lower than the rate they need to pay to borrow the money, so no trading would occur in the federal funds market. Therefore, the federal funds market would serve no purpose.  
> **username_0**: Okay. So you still did not get my point. I am saying 1 unit of fed funds support 10 unit of borrowing. So even if fed funds is say 2 percent, you would still be lending 1 percent if there is perfect demand and no risk . This is beacuse with 1 unit reserve, you are now lending 10 unit, which earns you ten times 1 percent, which is 10 percent.  
> **username_1**: Suppose bank A is the borrowing bank and bank B is the lending bank. Of course bank A would want to borrow because of what you stated above. However, bank B would not lend the funds to them for a long enough period of time for bank B to turn around and lend it in the public market. If bank A was looking to lend the funds, they would do so in the public market in order to make more interest. If this arbitrage of sorts you are speaking of could happen, every bank would be demanding funds in the federal funds market and no banks would be supplying them.  
> **username_0**: What you just said is correct. But still, theoretically banks can always roll over overnight loans, just like overnight repos.  
> **username_1**: Theoretically, this can happen. However, if banks did this, lending banks would cease trusting the borrowing banks and, as happened in my previous example, supply drops to zero.  

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### Answer by username_2 on 2015-12-02. Score: -3

The core premise of your question is correct. Banks receive a tremendous advantage from Fed actions and any discerning economist should be concerned over the amount of corporate welfare doled out banks....especially as they will take that money and engage in maturity mismatching which is an incredibly volatile, dangerous and inflationary practice that transfers wealth from the public to the private banking sector.

There are many such ways banks receive corporate welfare. This includes Fed dividends (for not loaning out 100% of our deposits!). It also includes interest on "excess reserves" (again our deposits). Troubled banks are given below market interest rates with discount window loans. But the bigger problem with the discount window is that it creates a certainty that the Fed will backstop bad behavior. Then there is the open market. The Fed overpays for REPO's from special banks (primary dealers). There is also a good reason to suggest the REPO market is being churned as well to encourage excess trading volume. But the big problem with the open market is it provides artificial liquidity guarantees to the banking system at large. If banks know that the Fed will ensure that the money market will hum along at a very low rate, then they are more apt to engage in maturity mismatching which creates inflation and volatility. The entire system is corrupt beyond belief and most economists are totally oblivious to this reality.

> **Comments:**
> **username_3**: Hi. This answer seems to mostly be opinion (and or rhetoric). Your answer would be greatly improved if you are able to back these statements up with any facts or possibly a model.  
> **username_2**: The question is not a math one.  It's one of policy.  You can not understand central banking without understanding the political philisophy behind its actions.  It is an illusion to keep separate economics from politics and any attempt to do so will result in confusion.  
> **username_3**: I didn't ask specifically for mathematical facts (it happens that I find models and numbers to be convincing but I understand people find different types of arguments to be useful). As is, your answer is a series of unbacked assertions. It would greatly benefit from a reference to any type of research (economic or political science based -- a newspaper article might even be better than nothing). Although I believe you and I disagree about this topic, a well informed answer I disagree with can still be a high quality answer.  
> **username_2**: A mathematical framework is worthless without proper conceptual context. eg I can mathematically calculate how fast a ball will drop using physics, but if I don't have the right variables/context (like wind resistance), my formula is worthless.  This is a conceptual/political paradigm  so political answers are apt. As for a references, this is a circular demand.  A statement can not not be validated by another.  To imply otherwise is to advocate dogma and mob logic.  If you have specific questions, I would be happy to answer them.  
> **username_4**: What @cc7768 is saying is that if you are going to make assertions, back them up. Don't respond by saying maths without the right assumptions is worthless, back up your own claims with evidence.  
> **username_5**: Math may be useless without context, but you can't just imagine a context that isn't there. Math is part of what we use to verify whether our understanding matches what is happening.  

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