The first Federal funds loan between banks took place in 1921, less than a decade after the Federal Reserve System was created. The Federal funds market became quite active in the 1920s, but its use ebbed and flowed over the ensuing decades. It became increasingly active in the 1960s as it proceeded to assume its current position as a key component of the modern commercial banking system.

Federal Funds

Motivation for Federal funds lending arises from reserve requirements imposed on commercial banks by the Federal Reserve System (the Fed). Reserve requirements are rules imposed by the Fed to ensure that all bank depository institutions (traditional banks, savings and loan associations, credit unions, mutual savings banks, and even U.S. branches of foreign banks) keep enough reserves to back up customer deposits. The bank depository institutions have a two-week period to satisfy the requirements.

Due to the normal fluctuation of banking activity, some banks have more reserves than needed to satisfy requirements and some have fewer. On a given day, one bank might have a large number of withdrawals that temporarily reduce reserves while another bank has a large number of deposits that temporarily expand reserves. The temporary lending of reserves is a logical response to such imbalances among banks. Banks that borrow reserves are able to satisfy reserve requirements and banks that lend reserves generate extra revenue for their trouble. This is a win-win exchange for both sides.

The Lending Process

• Bank to Bank: Most Federal funds lending is between banks with established working relationships. A short telephone call between banks is often enough to reach agreement on the terms of the loan. The lending bank then contacts the Federal Reserve System with instructions to transfer Federal Reserve deposits to the account of the borrowing bank. The process is quick, easy, and efficient.


• Federal Funds Brokers: Some loans, however, are arranged by third party Federal funds brokers, who specialize in matching up banks in need of reserves with banks who have extra reserves to lend. The brokers, of course, charge a commission for their effort, but they expand the market, providing greater access of lenders to potential borrowers and borrowers to potential lenders. The borrowing bank need not have an established relationship with the lending bank.

The Federal Funds Rate

Contrary to popular misperception, the Federal funds rate is NOT set by the Federal Reserve System, but rather determined by the interaction among borrowers and lenders in the Federal funds market. The Fed can influence the Federal funds rate through monetary policy, but it does not actually set the rate.

The Federal funds rate is a key benchmark rate for the banking system. In one sense, it represents the basic cost of obtaining funds, funds that can then be used for consumer and business loans. As such, other bank interest rates are invariably linked to the Federal funds rate. Should the Federal funds rate increase, then interest rates on car loans, construction loans, mortgage loans, and others will also increase.

And Monetary Policy