Modern Money Mechanics

A Workbook on Bank Reserves and Deposit Expansion

Page 24

Changes in Loans to Depository Institutions

Prior to passage of the Monetary Control Act of 1980, only banks that were members of the Federal Reserve System had regular access to the Fed's "discount window." Since then, all institutions having deposits reservable under the Act also have been able to borrow from the Fed. Under conditions set by the Federal Reserve, loans are available under three credit programs: adjustment, seasonal, and extended credit. The average amount of each type of discount window credit provided varies over time.

When a bank borrows from a Federal Reserve Bank, it borrows reserves. The acquisition of reserves in this manner differs in an important way from the cases already illustrated. Banks normally borrow adjustments credit only to avoid reserve deficiencies or overdrafts, not to obtain excess reserves. Adjustment credit borrowings, therefore, are reserves on which expansion has already taken place. How can this happen?

In their efforts to accommodate customers as well as to keep fully invested, banks frequently make loans in anticipation of inflows of loanable funds from deposits or money market sources. Loans add to bank deposits but not to bank reserves. Unless excess reserves can be tapped, banks will not have enough reserves to meet the reserve requirements against the new deposits. Likewise, individual banks may incur deficiencies through unexpected deposit outflows and corresponding losses of reserves through clearings. Other banks receive these deposits and can increase their loans accordingly, but the banks that lost them may not be able to reduce outstanding loans or investments in order to restore their reserves to required levels within the required time period. In either case, a bank may borrow reserves temporarily from its Reserve Bank.

Suppose a customer of Bank A wants to borrow $100. On the basis of the management's judgment that the bank's reserves will be sufficient to provide the necessary funds, the customer is accommodated. The loan is made by increasing "loans" and crediting the customer's deposit account. Now Bank A's deposits have increased by $100. However, if reserves are insufficient to support the higher deposits, Bank A will have a $10 reserve deficiency, assuming requirements of 10 percent.

Bank A may temporarily borrow the $10 from its Federal Reserve Bank, which makes a loan by increasing its asset item "loans to depository institutions" and crediting Bank A's reserve account. Bank A gains reserves and a corresponding liability "borrows from Federal Reserve Banks."

To repay borrowing, a bank must gain reserves through either deposit growth or asset liquidation. A bank makes payment by authorizing a debit to its reserve account at the Federal Reserve Bank. Repayment of borrowing, therefore, reduces both reserves and "borrowings from Federal Reserve Banks."

Unlike loans made under the seasonal and extended credit programs, adjustment credit loans to banks generally must be repaid within a short time since such loans are made primarily to cover needs created by temporary fluctuations in deposits and loans relative to unusual patterns. Adjustments, such as sales of securities, made by some banks to "get out of the window" tend to transfer reserve shortages to other banks and may force these other banks to borrow, especially in periods of heavy credit demands. Even at times when the total volume of adjustment credit borrowing is rising, some individual banks are repaying loans while others are borrowing.

In the aggregate, adjustment credit borrowing usually increases in periods of rising business activity when the public's demands for credit are rising more rapidly than non borrowed reserves are being provided by System open market operations.

Discount Window as a Tool of Monetary Policy

Although reserve expansion through borrowing is initiated by banks, the amount of reserves that banks can acquire in this way ordinarily is limited by the Federal Reserve's administration of the discount window and by its control of the rate charged banks for adjustment credit loans - the discount rate. Loans are made only for approved purposes, and other reasonability available sources of funds must have been fully used. Moreover, banks are discouraged from borrowing adjustment credit too frequently or for extended time periods. Raising the discount rate tends to restrain borrowing by increasing its cost relative to the cost of alternative sources of reserves.

Discount window administration is an important adjunct to the other Federal Reserve tools of monetary policy. While the privilege of borrowing offers a "safety value" to temporarily relieve severe strains on the reserve positions of individual banks, there is generally a strong incentive for a bank to repay borrowing before adding further to its loans and investments.

Adjustment credit is short-term credit available to meet temporary needs for funds. Seasonal credit is available for longer periods to smaller institutions having regular seasonal needs for funds. Extended credit may be made available to an institution or group of institutions experiencing sustained liquidity pressures. The reserves provided through extended credit borrowing typically are offset by open market operations.

Flexible discount rates related to rates on money market sources of funds currently are charged for seasonal credit and for extended credit outstanding more than 30 days.

26. A bank may incur a reserve deficiency if it makes loans when it has no excess reserves.

27. Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a direct credit to the bank's reserve account.

No further expansion can take place on the new reserves because they are all needed against the deposits created in (26).

28. Before a bank can repay borrowings, it must gain reserves from some other source.

29. Repayment of borrowings from the Federal Reserve Bank reduces reserves.

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