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
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.
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