Advertisements

Fed Funds Rate

Fed Funds Rate – Fed Funds Market

Now that we have seen how banks manage liquidity through the eurodollar market and bank repos, the third method to manage liquidity was through the Fed Funds market, which is nothing but domestic interbank borrowing and lending deposits at the Fed. Interbank borrowing and lending takes place though either correspondent banks called correspondent Fed funds or interbank market also called brokered Fed funds. The rate at which the borrowing and lending takes place is the fed funds rate. 


Importance of Bank Correspondents

The correspondent relationship between banks was a result of more regulations imposed on banks. To understand this we need to know a brief history about the banking system in the US.

Early banks were incorporated by either the state or federal charter. The banks incorporated under the federal charter called nationalised banks were given permissions to open branches nationwide. The First and Second banks were dominant banks with nationwide branches giving them the advantages over other banks in payments and deposit mobilisations. The bank was also a banker to the Federal Government.

The expansion of state banks were however restricted by their charters by strictly prohibiting the banks from conducting business outside the incorporating state. Prohibiting branches across state lines, engaging in the securities and other restrictions limited the scope and scale  of the bank to increase profitability.

In order to facilitate payments a bank in one city would form a relationship with a bank in other cities. These relationships are called correspondent banking relationships and the banks involved are called correspondent banks.  Besides facilitating payments a correspondent bank might also facilitate credit  extensions and or trading. Since each bank had a competitive advantage in the region it operated this correspondent relationship worked out quite well.

The correspondent banks would set up credit limits, policies and procedures to deal with the respondent banks – the smaller local banks. While the small country banks, the respondent banks, were specialised in mobilising deposits,  they would need the services of the larger banks to extend credit. These country banks surplus with funds would keep their balances with correspondent banks.

Now that we have a clear understanding of what correspondent banking is lets understand what the Fed funds market is. We will begin by understanding what correspondent Fed funds are.


Correspondent Fed Funds

The Fed funds market is a market in which banks lend to one another their deposits at the Federal Reserve Bank. The transaction is daily simple. Smallbank has a $10 million interbank deposit with Largebank. Smallbank withdraws its deposit with Largebank and then sells the $10 million funds to Largebank in the form of Fed funds. Largebank’s entries would be to reduce its liabilities with Smallbank by $10 million and purchase Fed funds by Smallbank.

The journal entries in the balance sheet would be

Smallbank

Assets

Deposit placed at Largebank

-10

Fed Funds sold to Largebank

+10

L + E

Largebank

Assets

L + E

Deposits-Smallbank

-10

Fed Funds Purchased

+10

In the case of correspondent Fed funds, no Fed funds are bought to sold. Its simply a transfer from one account to another account by the two banks. Fed funds purchased is a borrowing of Fed funds and Fed funds sold is a lending of Fed funds, termed in this manner due to historic reasons. This agreement now allows Largebank to pay interest on borrowings – based on the Fed Funds rate.

Since its a borrowing no reserves or deposit insurance is required. The participants in the Fed funds markets are those that can place deposits at the Federal Reserve bank such as banks, G-Sec dealers, thrifts, etc.

Hundreds of US banks participate in the Fed funds market including foreign banks. Banks having excess reserves lend to banks with deficit reserves generally on an overnight basis or sometimes on a term basis. Transfers are done via the Fedwire. These are unsecured loans made at the Federal Funds rate, which is an average rate at which these transactions occur. The Federal Reserve Bank uses the Fed funds rate as a tool to implement its monetary policy that we will see later. The FRB sets a target range for the Fed funds rate depending on economic and monetary conditions.


The Fed Funds Rate

A measure of the fed funds rate is the overnight or daily Fed Funds Effective rate (FFER) is calculated by the NY Fed provided by data from Fed funds brokers.  The Interest on Reserves or IOR is the rate depository institutions or other eligible institutions earn on their reserves at the Fed.

The components of IOR are interest on required reserves and interest on excess reserves (IOER). The IOER rate effectively provides a floor for the Fed funds rate since banks could keep the balances at the Fed rather than lending it to other institutions. This provides the Federal Reserves some control over the FFER.

Banks can arrange for Fed funds directly or through Fed funds brokers. These brokers that broker funds like government securities brokers submit the aggregate data on transactions to the NY Fed. Volumes done in the Fed funds market range anywhere between $70 billion to $120 billion.

As we have mentioned that majority of the transactions are routed via the Fedwire Funds Services. Fedwire is a communications network that links financial institutions to the Fed used to transfer Fed deposits between themselves. The lending institution authorises its district Federal bank to debit its reserve account and credit the reserve account of the borrowing institution. Most of the transactions are regular return transactions i.e. within 24 hour borrowings. There are also ‘early return’ transactions where the funds must be returned at a specific time before 24 hours. These would trade lower than the overnight rate.

We next study the functioning of another liquidity management tool used by banks – MMDAs or Money Market Deposit Accounts

Related Topics

Fractional Reserve Banking

Central Bank’s Monetary Policy

Bank Profitability

Technical Analysis

Online Courses – Fast Track to Becoming a Pro Trader

Advertisements
%d bloggers like this: