FED Funds Market- How does it work?
FED funds or Federal Funds are excess reserves with the commercial banks and other financial institutions deposit at regional Federal Reserve Banks, which can be lent to other market participants with insufficient cash on hand to meet their lending and reserve needs. The loans are unsecured in nature and are made at a relatively low-interest rate, called the federal funds rate or overnight rate, as that is the period for which most such loans are made. Since there’s no collateral, both the banks have a high level of mutual confidence. The Federal Funds rate is set by the Central Bank, but the actual rate is determined on the basis of the overnight inter-bank lending market.
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The FOMC (Federal Reserve Open Market Committee) sets the rate’s target at its regularly held meetings. This is called the fed funds rate. The FED uses open market transactions (buying and selling of securities from the market to regulate the economy) to encourage the banks to meet this target. The FED might buy the securities from the market and replace it with credit in order to decrease the rates. A low fed fund encourages lending because of the lower interest rates. The way the market works is that the banks are required to maintain a certain reserve based on a percentage of the bank’s deposits by the end of the day. As mentioned before, some banks will have excess reserves and some banks will have lower reserves. Banks with excess reserves will lend to other banks that have a deficit. Banks can also meet this requirement by borrowing from Federal Reserve’s discount window, at a rate known as the discount rate, which is usually higher than the fed funds rate (this is to encourage banks to borrow from each other).
Market before and after the Crisis:
The FED market has changed significantly after the global financial meltdown of 2008. Banking, in general, has been awash in reserves, with fed rates been near zero multiple times, but the market has continued to operate, albeit with differently. Different institutions now participate and government-sponsored enterprises now participate like Federal Home Loan Banks to loan funds, and foreign commercial banks to borrow.
What necessitated the change?
Between January 2008 and the end of the financial crisis in June 2009, the Federal Reserve’s balance sheet increased by 130 percent, swelling to $2.1 trillion (see figure 1 below). The balance in 2016 reached $4.4 trillion, increasing by $2.3 trillion. It consists of $2.46 trillion in treasuries, $26.81 billion in agency debt, and $1.76 trillion in mortgage-backed securities.
The main culprit for this was the increase in Quantitative Easing programs undertaken by the FED during and after the crisis, wherein the FED purchased a large number of longer-term securities like US Treasury debt and mortgage-backed securities that are guaranteed by GSEs like Fannie Mae and Freddie Mac. The QE programs flooded the banking system with liquidity and made it less necessary for banks to borrow in the federal funds market. Dodd-Frank act was also introduced, which had small changes to the FDIC’s regulatory standards, changes which have had a direct effect on the incentives that banks have to hold cash assets.
Domestic Depository Institutions can now receive Interest over excess reserves (IOER) and since the effective fed rate is below the IOER, the lending in the overnight market has largely been ceased. On the borrowing side, domestic institutions are flooded with Fed’s asset purchases, and the FDIC’s new capital requirements penalize them for holding reserves. A foreign bank with an interest-bearing reserve account can borrow from the FHLBs at the federal funds rate, store the cash in its reserve account, and earn IOER minus the rate paid on the federal funds.
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The link between the federal fund’s policy and the real economy has become more complex as a result of Fed and FDIC enacting policies that decrease the role of domestic institutions and increase the role of Foreign institutions in the Federal Funds Market. When a target rate increase is announced, is it accompanied by an increase in the IOER rate? Is the increase accomplished by a sale of securities that are held by the Fed, or is it accomplished by even less straightforward means, such as the Fed’s participation in the repo market? Each decision affects the market institution differently. Changing the rate at which banks lend to each other is harder now since the current balance sheet is so huge, an announced policy rate increase could possibly generate surprising results. Hence the large increase in the Fed’s balance sheet greatly changed the environment in which the FOMC declares its intention for interest rates by setting a target federal funds rate.
Author: Aman Aggarwal
About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.