Key Rate
It is the interest charged for borrowing loans from the federal government or other banks.
Key rates are the interest at which the banks borrow money from the federal government and other institutions. Banks often utilize these short-term loans to address urgent financial issues, fulfill reserve requirements, and maintain a healthy financial position.
The practice/regulation of fractional reserve banks causes a need for these loans. Since banks must withhold a fraction of all deposits they own, they must ensure compliance with this regulation. Sometimes a bank can approve too many loans and drop their balance below the required amount.
If this were to occur, most banks would take out a loan with the key rate as the interest rate. These loans serve the dual purpose of replenishing their required reserves and ensuring the bank's stability.
For example, when a bank is near or slightly above its required reserves, it has many outgoing loans or investments. This heightened risk exposure could jeopardize the bank's financial well-being.
If a bank begins to fail, a loan could save the bank. They could use the funds to pay back any debt or obligation. This could help bail out failing banks like the Silicon Valley Bank in 2023.
Even in cases where a bank is not facing imminent failure, a loan can serve as a safeguard against future problems. If a bank has a debt, they could pay it off with a loan with a more favorable interest or a longer term. If this were to happen, the overall risk for the bank would decrease significantly.
Key Takeaways
- Key Rates are the interest charged for borrowing loans from the federal government or other banks.
- The two types of rates are Discount Rates and Federal Fund Rates.
- Fraction Reserve Banking is the practice of having banks use deposits for loans but maintaining a small fraction of the total deposits at hand.
- Borrowing money helps banks maintain their fractional reserves.
- Banks fail by loaning out more money than they have without having proper safeguards.m
Types of Key Rates
Two primary key rates are used to meet required reserves: the Discount Rate and Federal Fund Rate. These two rates are manipulated by the federal government directly or indirectly.
By changing the rates, the federal government can affect the economy's supply of loans/money. This can boost the economy or curve inflation. Changes in these rates should be considered as they affect the lending in the economy and the stability of banks.
While Discount Rates determine the interest rate on Federal loans directly from the federal government to a bank or person, Federal Fund Rates pertain to the rate at which banks lend money to other banks.
These key rates are equally important as they address large portions of the economy. Let’s discuss the two in detail.
Discount Rate
Discount rates are the interest rate on short-term loans from the federal government. These loans are offered to commercial banks and other financial institutions. The discount rate and loan are applied for and given at the Fed’s lending window, known as the discount window.
These loans are used to finance operational costs when a bank is going through a hardship. Although most short-term loans can last days or months, these loans have 24-hour notice. This is an extremely short-term risk.
The loan includes an interest rate known as the discount rate, which is determined by the boards of the federal reserve and approved by the Board of Governors.
These loans are passed and given out by the 12 federal regional banks. These loans are mainly given out to banks that need to cover cash shortfalls, help with liquidity problems, or stop a bank from failing.
These loans can also be broken down into three subsections. More specifically, there are three tiers of these loans. As the tiers go down, the quality of borrowers decreases, and the interest rate increases.
1. Tier 1
This tier is also referred to as the primary credit program. This loan tier is used to help provide funds to banks in good standing, i.e., a bank with a good financial history, an excellent credit score, and overall stability.
These loans have little to no restriction on the amount borrowed and the use of the funds.
NOTE
The rate for these loans are often tied to or are changed to match the Federal Open Market Committee's target range for federal rates.
2. Tier 2
Tier 2, the secondary credit program, is aimed at borrowers who didn’t meet the requirements for tier 1 loans. These banks often have below-average credit scores and worse financial histories than tier-1 banks.
This makes these loans more riskier for the federal government. These loans tend to have more restrictions placed on them. For example, there may be limits to how much a bank can borrow or what the funding can be used for.
NOTE
Compared to tier 1 loans, these loans tend to have a higher interest rate. This helps balance the extra risk the government is taking on when giving out these loans.
3. Tier 3
Tier three, or the seasonal credit program, when compared to all tiers, is the riskiest of loans. These loans serve institutions that have seasonal changes. For example, smaller or local banks don’t have the outreach for consistent profit.
Their profits will come in waves when residents take out loans. This is the riskiest of banks, as their income isn’t guaranteed. This causes these loans to have the most restriction and the highest interest rates.
Federal Fund Rate
The second type of Key Rate is the Federal Fund Rate. This is the target interest rate set by the Federal Open Market Committee (FOMC). This rate is the interest posed on loans from one bank to another.
These short-term loans often happen overnight as banks are required to hold a fraction of their deposits to maintain stability. The federal government requires that banks hold a fraction of their reserves to protect against large withdrawals.
A bank falling below the mandated reserve percentage would violate the law. Fortunately, punishment isn’t instant.
There are periods when inspections are made to see if a bank faithfully follows the law. If a bank is caught with a reserve of less than the mandated amount, it will be heavily penalized.
NOTE
Currently, as of May 2023, the rates stay around 5-5.25%.
To counter this, most banks borrow from other institutions to meet the difference. These loans are often overnight due to the dire nature of the loans, and the federal government determines the interest rates.
These rates are discussed by the FOMC eight times a year. They alter the rate to maintain the economy. For example, in the 1980s, the rates were as high as 20%, but in March 2020, the rate dropped to nearly nothing.
Fractional Reserve Banking
Fractional Reserve Banking is a system most banks adopt to generate profits beyond the interest earned from loans. Although interest can increase the overall repayment of loans by thousands of dollars, the interest comes through in small denominations.
To turn a profit, a bank would need to loan out enormous loans. This has an inheritance risk. With a large amount of risk, a bank can fail if some borrower doesn’t repay their loans.
To solve this problem, most banks have adopted a system called “Fraction Reserve Banking.” This banking system uses the money banks store in a person's account. They take this money and invest it to make more money.
For example, if you open a savings account, the bank can access the fund you deposited to use and make investments. This system is the core of fractional reserve banking.
The bank can invest or give out more loans with this excess cash. With these new sources of capital, the bank can now make more money and profit even more. Although this system seems greedy, there are benefits to this type of banking.
Most of the deposits for a savings account won’t be used until a year later. This takes money out of circulation and harms the economy. When money sits in a savings account, it can fall victim to devaluation.
As the economy grows and inflation increases, any cash left inside a savings account will not keep up with the economy. By allowing banks to access this cash, deposits can re-enter the economy without directly harming the depositor.
This is especially prevalent when loans are involved. When deposits are used to give out more loans to businesses, those businesses can grow and expand. This expansion boosts the economy.
Additionally, mortgages do the same. When a person buys a house with a mortgage, they have a more stable life and therefore are more financially secure. With this, they can possibly try and improve their employment.
A main concern with this system is the worry of large withdrawals. While a large wave of withdrawals can harm a bank, most banks have enough cash to allow many borrowers to withdraw all their deposits.
If the worst were to happen, banks would usually try to sell any assets they own to make the difference. If that doesn’t work, the federal government will step in. Any money up to $250,000 in a bank that the FDIC insures will be recovered even if the bank fails.
How Banks Fail
Although banks and other credit institutions are meant to be secure and make well-informed investments, this isn’t always the case. Banks facing ill-informed decisions or losses can lead to financial instability and potential failure.
To minimize this, banks will be required to hold a certain amount of cash to have some capital to fall back on in case a large surge of withdrawals were to occur.
In cases like these, the effect could be catastrophic! Some banks will even shut down and fail!
Real-life examples include the recent failure of the Silicon Valley Bank.
The Silicon Valley Banked failed due to a combination of uninsured deposits and disproportionate investments. While SVB did see an increase in its stock price from 2020-2022, most of these deposits came from tech and start-up companies in the area.
As these companies grew, their deposits increased significantly, surpassing the insured amount protected by the Federal Deposit Insurance Corporation (FDIC). Many of these deposits were in the millions, resulting in a majority of SVB's deposits being uninsured by the FDIC.
Additionally, combining this with investments in treasury bonds and mortgage-backed securities from the federal government. This gave SVB 2 large weaknesses.
Before the failure, most tech companies suffered through the collapse of the tech boom in November of 2021. This caused most of these tech companies to begin to withdraw funds to support themselves through the collapse.
This drained the reserves that SVB had held during this time. But the final blow came from inflation.
NOTE
During that time, as inflation began to rise, the federal government and most banks began to raise interest rates.
Because of these rising interest rates, most investments (mortgage securities, treasury bonds) began to lose value. Because these investments are held until maturity, other securities would make more money than HTM securities.
Depositors quickly learned of this devaluation and ran to withdraw all the funds they had deposited. Since most of their funding was uninsured, it was paramount that they quickly withdrew their fund in case SVB couldn’t pay off what it owed.
This caused a storm of frenzy that left SVB in failure. The combination of the large withdrawals and panic drained SVB of any deposits they had left.
Summary
Key Rates are an important part of banking, specifically Reserve Banking. While Reserve Banking ensures that banks have enough money to support themselves during large withdrawals, Key Rates help to ensure that banks can maintain their reserves.
Federal Reserve Banking helps banks to maintain a certain amount of money to cover large withdrawals. These reserves are mandatory and must meet a certain percentage of all loaned-out deposits.
Discount Rates allow the federal government to directly help these banks while Federal Fund Rates allow other banks to support each other and maintain a strong economy. These rates are integral for banks and depositors for banks.
While Discount Rates and Federal Fund Rates serve the same purpose, they are drastically different rates pertaining to their specific type of loan.
Rates and loans like these help to stabilize the economy and prevent bank failures such as the recent Silicon Valley Bank failure. It's important that these rates are maintained and these loans are always available to these credit institutions.
Although the average investor or citizen will not have to use this knowledge daily, it's still important to understand how these key rates can affect your bank and your account.
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