Banks are financial institutions that keep individual and business funds. They also engage in regular lending of money to interested businesses and individuals at rates set by the Federal Reserve. Let’s look at what the Federal Reserve does, and what are the costs banks incur when borrowing money from the Federal Reserve.
Overview of Federal Reserve
This is one of the most complicated financial institutions in the world, however, its influence spans many countries. The Federal Reserve is mandated by the US government to regulate the economy and provide financial stability to the country.
Functions of the Federal Reserve
Here are the key functions of the Federal Reserve:
Monetary policy regulation via influencing credit
They are expected to conduct how the US will be stable and make crucial economic suggestions. This they do by influencing how cash is distributed all over the country.
Supervision and control of Financial institutions
The federal reserves are known as the Bank of other banks. It controls how banks operate, their lending rate, their minimum balance, and how much cash they can borrow from the public. It also disciplines erring banks who violate the reserve policies and go against their ethics.
Maintain financial stability of the financial institutions and limit risk
It serves as a watchdog that checks for risk which may negatively affect US financial systems and prevents them offers financial services to the Government. The Federal Reserve plays a huge role in looking over the nation’s payment systems and as well transactions that concern the American government.
Why a bank may need to borrow money from the Federal Reserve?
Banks don’t usually like to borrow from the central bank, they prefer bank-bank lending. Here are some reasons that they would resort to the fed:
It is usually a last resort for banks to patronize federal reserves. It would mean they have a huge financial need which their fellow banks cannot help out. This type of loan is usually long-term.
Whenever the country is in a state of economic troubles like inflation, the Banks can approach the Federal Reserve to bail them out. However, whenever the central banks lend during inflation rate, they direct the banks which industries to prioritize.
During a discount window
A discount window is a specific time when Federal Reserve calls on banks to borrow from it. During this window, banks can approach the Federal Reserve for loans, at good rates.
Cost banks incur when borrowing from the Federal Reserve
There are some costs banks would incur when they borrow from the central bank, they include
Just like interest banks collect from people they borrow money, the Federal Reserve also collects a certain interest rate from banks who approach them to borrow money. This interest is determined by the federal funds which is agreed by directors of the central bank.
This is known as the annual percentage rate which is the aggregate cost of the loans the bank wants to borrow. The APR consists of the interest rates and other additional costs.
Loan processing costs
These funds are the total cost banks spend to complete the borrowing process from the federal reserves. It includes loan fees, broker, and closing costs.
Banks borrow money from the Federal Reserve, however, it is usually the last resort because they don’t want the reserve to think they have financial issues.