Banks are required to maintain reserves against their deposits. They borrow money when their reserves dip below the required level. When a bank falls into this situation, it has two choices -- it can borrow from the Federal Reserve or it can turn to another bank that has a reserve surplus.
Interbank Loans and the Federal Funds Market
Banks are regulated by the Federal Reserve System and state regulatory agencies. One requirement that the Federal Reserve -- the Fed -- places on banks is that they maintain a fraction of their deposits in reserves. Reserves include vault cash that the banks hold and deposits they have with the Fed, which is the banks' bank. The reserve requirement varies according to the type of account, but is generally in the 10 percent range. If a bank experiences big withdrawals and its reserves fall below the required level, then it must borrow the money to make up the deficit. Reserves must be maintained continuously, so a bank must cover a deficit on an overnight basis. The Fed is considered a lender of last resort, so a bank with a reserve deficit will most likely borrow from another bank that has a surplus. The market for interbank loans is called the federal funds market and the rate banks charge each other is the federal funds rate.
Thomas Metcalf has worked as an economist, stockbroker and technology salesman. A writer since 1997, he has written a monthly column for "Life Association News," authored several books and contributed to national publications such as the History Channel's "HISTORY Magazine." Metcalf holds a master's degree in economics from Tufts University.