Why banks borrow from each other

Question

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is the change in the value of deposits: if bank A had 100M in deposits and kept 10M as a reserve, if 2M deposits were withdrawn then it has a reserve of 8M whereas it has to keep 9.8M = 10%$\times $98M reserves, so the bank A needs to get 1.8M somewhere.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?

Answer 1

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)

Answer 2

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...

Answer 3

"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.