# Why banks borrow from each other

I was reading on the topic, and would like to be sure that my understanding is correct. For the benchmark I would consider American banking system as I've mostly used sources such as FRS and Federal Bank of New York when doing reading.

Banks are required to keep some percentage of their deposit money (say, 10%) in vault cash or at Fed. If the bank A does not have enough reserve, it has to borrow it either from another bank B (with an excess reserve) or directly from the Discount Window at Fed. The Discount rate at the latter is usually relatively high as Fed wants banks to borrow from each other, so bank A is likely to make an overnight loan with bank B. The rate at which this loan is made is called Fed Funds Effective Rate (well, the latter is a weighted average of all such rates) which is kept by Fed close to the target Fed Funds Rate by performing Open Market Operations. This is all clear to me.

What is not that clear are the reasons why some banks would have not enough reserves whereas others will have excess reserves. I guess, at least one reason is the change in the value of deposits: if bank A had 100M in deposits and kept 10M as a reserve, if 2M deposits were withdrawn then it has a reserve of 8M whereas it has to keep 9.8M = 10%$\times$98M reserves, so the bank A needs to get 1.8M somewhere.

I guess, there may be another reason which is heterogeneity in the investment opportunities. Suppose, bank A still holds 100M and has 10M in reserves. Now, there appears a very sweet deal which requires investing 1M today to get 2M back at the end of month. If bank A invests this 1M, then it has only 9M as reserves and needs to borrow 1M from somebody else. This somebody else may have excess reserves since such sweet deal was not available to him, it was only available to bank A - otherwise why give 1M to bank A for a fairly little interest, if you can double this money in a month.

My questions are: is this second reason underlying interbank lending reasonable? Is it also related to middle-term loans made at LIBOR rate (I don't think they are used just to meet reserve requirements, or are they)? Are there any other common reasons why banks borrow from each other - or equivalently why some banks would like to borrow whereas others would like to lend?

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First point to consider : some banks are by nature "positive" in their account to the central banks , for instance classical saving banks tend to get more deposit than loans; conversely others are more engage in loans activity (investments banks..) and are by "nature" borrowers on Interbank markets.

Secondly (the point you underestimate), mandatory reserves is not the only point, when a bank A lends money to someone it has also a certain percentage of that loan that it has to keep as "capital requirement" ( cf Basel agreements) : it is the main source of central money "leaks". This capital requirement is much more money's bank central consuming than reserve requirements. That’s the reason why banks borrow each other’s and why central banks have, at the end, the control of the money supply.

NB : In case the bank A lends (pure money creation) a certain amount to, let’s say "M.Doe" , bank A needs to keep a percentage of this amount in capital reserve. Moreover If M.Doe keeps this money in its bank (A) there is no others problems, however if M.Doe use this money to pay M.H which has an account in another bank (B) then the bank A will have to give central banks money to banks B, and this a source of liquidity needs. (cf money multiplier)

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So the first point does generally fit "the heterogeneity of investment opportunities": saving banks just don't invest as much and in such places as investment banks do. Right?  Thanks for mentioning the capital requirement. I read on that topic a bit now, so banks have to have enough equity - say at least 8% of their risk-weighted investments. If the bank does not have as much, he would like to borrow these money from other banks. Now, again - why would some of the banks have surplus and some would need money? –  Ilya Jan 19 at 22:52
As these regulations apply to the majority of big banks in the US at least, I would expect that again if all the banks would have an access/will to invest in the same places, then nobody would lend money to others - am I right here? –  Ilya Jan 19 at 22:53
Finally, do you mean that the borrowings with maturities 1/3/6/12 months that LIBOR are mostly due to the fact that banks need to meet capital and reserve requirements (the former being a more important driving force)? –  Ilya Jan 19 at 22:56
1: yes, + “heterogeneity of depositors/lenders” // 1b : wrong : the bank has others possibilities : Asset’s sales,Federal reserve, raise capital, decrease its lends (asset side). Then it’s a matter of strategy, risk management, profitability, liquidity position… //3 :wrong, withdrawal exists @quantycuenta .// 4(Libor) : i don’t know ...sorry; Finally, If you want to go deeper in thinking I recommend you the traditional “Economics of Money, Banking, and Financial Markets“ by Mishkin. Indeed the (International) monetary system is complex and can’t be summarized in few lines. –  Malick Jan 20 at 1:20
I'll need to see Mishkin's book then, didn't know that it's classic already :) what is 1b btw? –  Ilya Jan 20 at 2:50

The interbank rate probably isn't reasonable given your second example. However, between the constant capital flows going back and forth between thousands of banks on a daily basis and the asymmetric nature of the banking model, it's difficult and unrealistic to determine a fair market rate between the two parties. As far as I'm concerned, bank A got the better end of the deal even if bank B did walk away with some haircut.

Benchmark rates found in LIBOR, Treasury Yields, Discount Window Rates, are the best the banking system can do as far as a one-rate-fits all solution. So in the event bank B wants to loan his excess reserves again, he at least have some starting point on how much to charge...

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Thanks, I understand the whole complexity of determining fair rates for the IB lending market. Due to the fact that there is usually a spread between FFR and LIBOR, I guess the reason is as follows. The former is a market rate, but controlled by Fed via open market operations to balance demand and supply of Fed Funds primarily regarding the Reserve Requirements. The fact that LIBOR is different suggests that it is used for other reasons rather than not meeting Reserve Requirements. My question is for which reasons is it used, and why some banks would need to lend and some to borrow insuchcase. –  Ilya Jan 19 at 23:00
I have a hard time understanding your question...but I'll take a crack at it... –  File_Not_Found Jan 24 at 20:28
My interpretation as to why LIBOR is used over FFR is for securitization purposes. As you know, LIBOR rates changes daily while the FFR does not. If you look at the time series charts, FFR rates look like "ladders" since the Federal Reserve engages in the open market only when they feel the need to. Whereas the LIBOR time series charts exhibit behaviors similar to any other exchange-listed tradable security. –  File_Not_Found Jan 24 at 20:34
The benefit is for investors/hedgers/speculators to customize interest rate swap/FRA/cds terms. Additionally, these same securities reflecting the rates they are benchmarked against won't be "static" as they are benchmarked against a constantly readjusted rate. –  File_Not_Found Jan 24 at 20:37
And as far as why why banks would need to lend and borrow, there's really just a myriad of reasons that you cannot cover. As banks are in the business of risk management, things happen. People default, of business loans decide to repay their balances earlier than expected. Banks can end up depleted when debtors default and or with more money than they'd like to have when debtors repay ahead of schedule - resulting in a problem where they may need to borrow or loan to another bank in order to meet reserve requirements or to put capital to work, respectively. –  File_Not_Found Jan 24 at 20:41

"Capital requirements" is a misnomer as a minimum quota is not being placed on liabilities thus equities but on assets.

Banks are required by most national laws to hold a portion of assets "in reserve", cash or deposits at the banknote issuer, a central bank.

A reason why one bank might have a deficit of reserves is because it has met with withdrawals in excess the rate that loans have been repaid, frequently the result of higher relative demand. Withdrawals are paid with cash or accounts at the banknote issuer. To satisfy reserve requirements, a bank need only to borrow reserves from another. The worst case is that reserves are drying up because they're being used to satisfy withdrawals made out of fear of a bank's bad assets.

The opposite is the most likely case for a normally functioning bank: it has experienced less relative demand relative to the rate of deposits, so it has an excess of cash that needs to be loaned.

Overnight rates are the interest rates charged for the loans made by those with excess reserves to those in deficit. They are overnight because interest rates are usually adjusted overnight to allow those in deficit to attract withdrawals or slow new loans while those in excess can pay less interest rates for deposits while simultaneously lowering interest rates demanded for loans to attract more demand.

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I see, so your point is that banks would need to borrow/lend due at this particular day to heterogeneity of the net cash flows of deposits and loans close to that day. This is clear to me. It seems though what are you talking about are still Reserve Requirements - those on the assets sides (which percentage of deposits you have to hold), whereas there are also Capital Requirements on the liabilities sides, and those seem to be different regulations as @Malick mentioned. –  Ilya Jan 19 at 23:06
@Ilya Yes, that's definitely true. I was using the historical usage of "capital requirements", which isn't really relevant anymore since most use it in the more sensible way you and Malick described. I was only trying to highlight that fact because in older literature, the term will often be used in the way I criticized because the liability side became regulated after the asset side, and "capital" in those days referred to the assets, such as "capitalized with...". I only intended to remove confusion for further research. I apologize for adding to it by writing when tired. –  user6500 Jan 20 at 1:08
I see, thanks for the answer –  Ilya Jan 20 at 2:51