Economics of Money and Banking: The Role of Reserves and Liquidity Managament

How do banks make profit?

• A bank can make profit by using its excess reserves (which it gains from checkable deposits) as loans instead of reserves

• The bank makes a profit because it holds short term liabilities (like checkable deposits) and uses the proceeds to buy long-term assets like loans with higher interest rates

Liquidity Managament

• The acquisition of sufficiently liquid assets that the bank is able to meet its obligation to depositors (and return deposits to depositors)

• Large withdrawals of deposits from a bank might cause a liquidity crunch, where liquid assets are used to meet obligations

Reserve Shortfall

• Occurs when a banks reserves are exhausted, often by deposit outflows

• The shortfall is the amount of reserves that the bank is required to have and must provide 

Borrowing for reserve shortfall

• A bank may choose to meet the minimum reserve requirement by borrowing from other banks in the overnight market or from corporations 

• The cost of this activity is the interest rate on the loans (such as the overnight interest rate)

FED for reserve shortfall

• Banks might choose to borrow from the FED to meet minimum reserve requirements

• Borrowing from the FED incurs interest payments based on the discount rate

Selling Securities for reserve shortfall

• A bank might choose to sell securities to meet minimum reserve requirements

• The cost of selling securities is brokerage and other transaction costs

Securities

• Tradeable financial instruments that represent a monetary value such as stocks and bonds

Reducing loans for reserve shortfall

• A bank might decide to decrease some of its loans to meet the liquidity shortfall, which it can do by calling them in or selling them off

• This is the most costly way of acquiring reserves; it often involves selling loans to other banks, which might be reticent to buy them unless they are discounted

Why do banks hold excess reserves?

• Banks hold excess reserves as insurance against the costs associated with deposit outflows

• Having a reserve shortfall could be a problem as it might incur penalties; the existence of a shortfall could be a sign that a bank is not managing its liquidity effectively

What is the discount window?

• A mechanism which allows financial institutions to borrow from the FED after executing legal agreements and pledging collateral

• It allows for banks to manage their liquidity and refrain from withdrawing credit during times of stress

Primary credit

• The main program for borrowing in the discount window, which a bank qualifies for if it is in a generally sound financial condition

• When market rates exceed primary credit rates (borrowing from markets is more expensive) banks are encouraged to borrow at the primary credit rate (this makes the discount window a helpful tool for implementing monetary policy)