(eli5) Why does it take Feds to decide what the interest rate(federal funds rate) between two commerical bank is. Why can’t two independent commerical bank decide for themselves how much interest they are willing to charge

Question

This has really been bugging me. Really appreciate it someone could explain it in simple terms

In: Economics

Answer 1

Anything regarding this is going to be simplified a lot.

Commercial banks can lend each other money at whatever rate they choose but the discussion here is about very short term (days) loans at the Fed Reserve Bank that all banks must maintain their reserve accounts at. The issue at hand is that the Fed themselves lend money to the commercial bank. So it wouldn’t really make much sense for Bank A to borrow money from Bank B at 10% (say) when the Fed itself is willing to lend to Bank A at 6% (say). This 6% is called the Fed Discount Rate (FDR) and is why the Fed is called the lender of last resort. Banks can always resort to this

In the above example, there is no prohibition for Bank B to offer the loan to Bank A at 4%, for example. This is the practical effect of the Fed Funds Rate – it is effectively a ceiling. In the above example the FFR might be 5.75% ie very close to the FDR. There is not much incentive for Bank B to give less than the FFR (earns them less) and not much incentive for Bank A to pay more than the FFR (costs them more).