It's late afternoon and Flanders Community Bank is short on the available cash it is required to hold in reserves. It has plenty of assets, such as loans it has made to customers for cars, homes or education. However, it must have the required cash in case its customers come to the bank to make withdrawals. For example, suppose a customer came in for a $1,000 withdrawal and, instead of cash, the teller offered the customer a different customer's car loan. The conversation might go like this:
Customer: "Good morning. I would like to withdraw $1,000 from my account."
Teller: "Okay. Here you are. This is a promissory note another of our customers signed when he borrowed money from us to buy a car. In this loan contract, he states he will pay back $1,000. Of course, that means that this note is worth $1,000."
Customer: "Wait a minute! This is no good to me. I can't spend this right now. This isn't liquid. It will take too long to convert this into cash – and I need cash!"
It's important that Flanders Community Bank not be caught short on cash because it cannot pay its customers in other people's loans and other non-liquid assets. However, it's late in the day and it's too late to arrange an overnight loan from a fellow bank. How will this bank get the cash it needs? Flanders has another option: It can borrow the cash from the Federal Reserve.
One of the most important ways that the Fed provides liquidity to the banking system is by offering funds for loans through its discount window. Traditionally, banks would come to the discount window for loans only when they could not borrow from any other institution.
However, during the period December 2007 through March 2010, the Fed used the discount
window in a new way to help sound banks obtain additional funds that they could
then lend to businesses and consumers. One new method for lending money to banks
through the discount window was the Term Auction Facility, the TAF for short.
The TAF worked like this:
- Every two weeks, the Fed would determine the amount of money it wanted to lend on a particular day. It would set a minimum interest rate at which it was willing to lend the money.
- The banks that wanted to borrow would bid on the amount of money they wanted to borrow and the interest rate they were willing to pay.
- The Fed would sort the bids according to the interest rate offered.
- Then, beginning with the highest interest rate and working its way down, the Fed would add the amounts of money requested until the amount requested equaled the amount the Fed wanted to lend. The interest rate charged would be equal to the lowest rate offered among the banks whose bids were accepted.
Note: The last term auction was held in March 2010.
The Fed lends money to banks so that a shortage of funds at one institution does not disrupt the flow of money and credit in the entire banking system.
See it in Action: Borrowing from the TAF