Why isn't the Fed funds rate greater than interest rate on loans to the pubic

Question

First of all, fed funds rate is the rate banks borrow reserves' from each other. Interest rate on loans is the rate the bank charges to public for its loan. From one line of logic, we think of the rate bank charges to public should clearly be greater than the interest rate itself bear to borrow since banks are making a margin. And empirical data clearly support it.

However, another line of logic does not quite support it. We know the banks borrow reserve money in fed funds market, which is clearly better than the money it lends to the public in the following sense: one unit of fed funds can support 10 units of additional deposit if the reserve-deposit ratio is 10%. So the banks with this addtional 1 unit of reserve, can theoretically make 10 more units of loans and therefore creating 10 more units of deposit. So reserve is better money. Hence, theoreticaly, the fed funds rate should at leastbe higher than the rate banks make loans to the public, if not 10 folds.

My question being whether there is a logical fallacy in my understanding and if not, what kind of reality deviated it from theory.

Answer 1

I think you are missing the credit risk attached to any loan. You, as an individual borrower, are far more likely not to reimburse your loan than a bank. Thus the loan is far less risky.

Central bank money could only be qualified as "better" (even that does not mean much) because it is issued by the Central bank, deposits are issued by commercial bank, so you bear the risk that your bank fail, but it happens that in most country individual deposits are insured by some state agency. So I cannot really see why central bank money would be better than deposits.

Nowadays, the amount of reserves that a bank must hold does not actually play a big role in the economy (as opposed to what most of economic textbooks and economic professors are teaching in undergrad schools). The most important part is the interest rate that is paid on those reserve, which is fixed by the central bank and which act as an opportunity cost for the bank when it decides to lend to an individual rather than holding reserves.

However I see your point, but the fact is that this way of thinking is misleading. Banks create (in theory) as many loans as they want, because there are no physical constraints, if you want, that prevent them to do so. The only constraint is a regulatory constraint that states that in order to remain solvent (in order to be able to repay the depositors) banks should invest x% of the assets in reserves. Those reserves would be held on a central bank account in central bank money, and the return on those reserves will be the fed fund rate decided by the central bank (the same way a commercial bank decide how much interest it will pay on your savings account). So it is true that one more unit of reserves gives the right to issue more than one unit of loans but this does not mean that one money is better or worse than another. It's is just a matter of regulation.

It may be hard to get, but the point is really that central bank money is safer so cheaper than deposits, no matter what regulatory constraints apply to banks.

You may want to read this paper which may be a bit complicated but you should get the intuition. This two docs may be simpler (with nice pictures) : doc 1, doc 2.

Answer 2

Loans in the federal funds market are also nicknamed 'overnight loans.' This means they cannot use that money to make loans because the money gets returned as soon as the bank's reserves are cleared by the Fed.

If the lending bank was willing to use the money for an asset such as a loan, they would simply loan it to a consumer at the higher rate. There is no way that a bank would loan to another bank for any long period of time because, as you pointed out, they can get a higher rate of return by loaning it elsewhere. Typically, the banks that are lending in the federal funds market are banks who have decided to hold excess reserves for one reason or another. If the bank was looking to loan the money for a period of time, they would have already done so outside of the federal funds market.

Also, if the federal funds rate was higher than the nominal interest rate, banks would not go to the federal funds market to get a loan (because they can get one for cheaper in the public market), which would make the existence of a federal funds market pointless.

Answer 3

The core premise of your question is correct. Banks receive a tremendous advantage from Fed actions and any discerning economist should be concerned over the amount of corporate welfare doled out banks....especially as they will take that money and engage in maturity mismatching which is an incredibly volatile, dangerous and inflationary practice that transfers wealth from the public to the private banking sector.

There are many such ways banks receive corporate welfare. This includes Fed dividends (for not loaning out 100% of our deposits!). It also includes interest on "excess reserves" (again our deposits). Troubled banks are given below market interest rates with discount window loans. But the bigger problem with the discount window is that it creates a certainty that the Fed will backstop bad behavior. Then there is the open market. The Fed overpays for REPO's from special banks (primary dealers). There is also a good reason to suggest the REPO market is being churned as well to encourage excess trading volume. But the big problem with the open market is it provides artificial liquidity guarantees to the banking system at large. If banks know that the Fed will ensure that the money market will hum along at a very low rate, then they are more apt to engage in maturity mismatching which creates inflation and volatility. The entire system is corrupt beyond belief and most economists are totally oblivious to this reality.