Why does the Federal Funds Rate matter if the current reserve requirement is 0?


My understanding is that the Fed Funds Rate is the rate at which Bank A charges Bank B for lending excess Bank A reserves to meet Bank B’s reserve requirements. But if the current reserve requirement is 0, why would Bank B need to borrow from Bank A in the first place?

In: 5

The short answer is that interbank lending exists for many reasons besides reserve requirements, and as you can see, the market is still quite active:

While we often think of the Fed as policy-making body, it actually serves as a lot of the transactional ‘plumbing’ behind financial markets. Most US dollar wire transfers go through the Fed. When you send money from an account at Bank of America to an account at Wells Fargo, instructions are sent to the Fed to move money from BoA’s Fed account to Well’s Fargo’s Fed account. Banks need to keep large cash cushions in their Fed accounts to handle the day-to-day variability and funding requirements of operating a bank. Some days the wires you send out will outnumber the wires you receive. It will eventually even out, but in the short term you get a loan just to be safe.

For liquidity. Banks still need to move money around. Be it paying employees or funding withdrawals. The reserve requirement being 0 just means they don’t have to hold their reserves in cash. They could instead hold those reserves into longer term investments as long as they keep enough money on hand to continue their normal operations.

Let’s say Bank B has a bunch of its assets held in longer term bonds that don’t mature for 5-10 years. And let’s say interest rates suddenly spike, which drops the value of the bonds below their face value because people can just buy newer bonds that give higher interest rates. Let’s say Bank B suddenly runs out of money to fund withdrawals and the only thing they have left are those bonds. Suddenly their only option is to either sell those investments or borrow money from Bank A. They would rather borrow the money from Bank A so they can hold onto the bonds until maturity when they get all their money back plus interest rather than eating a loss.

FYI this is why the Fed isn’t too worried about bank runs with the recent bank crashes. Because regulations have forced the larger banks including the TBTF banks to keep a very high ratio of assets that can be liquidated quickly without a huge loss despite the reserve requirement being 0. The CET1 ratio in a lot of ways replaces the reserve requirement. You can read more about it here: https://www.federalreserve.gov/publications/large-bank-capital-requirements-20210805.htm

Pretty much all of the banks had a really low ratio going into 2008 like today’s SVB, First Republic, and so on. Today large banks have a very high CET1 ratio that makes a repeat of 2008 really unlikely. That said, smaller banks that are not required to maintain that ratio are at risk of repeating their own little version of 2008.

I’m a repo trader at a bank so this is one of the few things I know way too much about. Since this is Explain Like I’m Five and not Explain Like I’m (Series) Seven, I’ll give it a shot.

Most people think of money as a fixed number. Like Elon Musk is worth (X – 44 billion) dollars. So if a bank has some Y (where Y > 0) amount of cash at the bank’s bank account, why does it need to borrow? But that’s not how banks think about money. We think of it more of a flow concept. Think about electricity in your house. Electricity generated now must be consumed at the same instant.

Some days, your family needs a lot of power. Maybe it’s cold out and all the space heaters are running. Maybe your brother got heavily into Bitcoin mining, which as every five year old knows, uses the more energy-intensive and laborious proof-of-work instead of proof-of-stake which requires a ton of electricity to power all those ASICs. Whatever the case, now your parents have to “borrow” money from the power company. The rate is set by the local power company. Similarly, some days a bank is using up a lot of cash. Then it has to borrow that need from the “utility” – the rest of the financial system. That rate is set in reference to the Fed Funds rate.

Some times, the fam needs a lot less power. Mom got a cool new set of solar panels and now the house is producing more power than it uses. Sounds great! But it’s not easy to store power. So it is better to “lend” power back to the utility for some money by pumping it back into the grid. That rate is also set by the utility. Likewise, it’s expensive (for various grown-up economic, accounting and business reasons) for banks to sit on tons of excess cash. So people like me lend out that money to the grid of banks and financial institutions that need it that moment. That rate I get is also benchmarked to Fed Funds.

That gives that Fed a lot of its power. If it cranks up the Fed Funds rate, banks want to do whatever it takes to borrow less. Like if PG&E jacks up your family’s rate so it can burn down more forests, your family will “borrow” less power. Maybe your mom will get even more solar panels. Maybe your brother will switch to Ethereum mining.

The thing is, like power, the system not collapsing depends on supply (of power and of loanable funds) to be almost exactly in line and equal to demand. If the bank has more money than it needs, it sucks and costs money and the finance department screams at me but it’s not the end of the world. If the bank has less money that it needs that day, that’s even worse. Traders call this position of having negative dollars on deposit as “going tits up”.

Of course if my nips rotate fully to the 12-o-clock position and my bank goes under, every other bank I do business is also in a world of hurt because their money they lent to me just went bye-bye and the demand for their money exceeds their ability to produce it, they too go bust. If a big nuclear power plant fails, and the rest of the grid cannot spin up enough generators to fill the whole, the whole power grid collapses.

Thus, for both individual and systemic reasons, banks will err greatly to the side of holding more cash on hand than what is legally required on reserve. But everybody shifts between lending and borrowing, so today I may be lending and tomorrow, I may be borrowing money. But borrowing still goes on.