Existence of Banks

If, however, there is a money shortage then the Fed has the option to use an instrument to inject money into the economy by using a repurchase agreement. (Repo). This is a short term, often a few days, loan made out by the bank that is secured. A Repo is the exchange of a security for reserves with the agreement to reverse the transaction in the future. On the day of the transaction, the Fed deposits money in a primary dealer’s reserve account, and receives the promised securities as collateral. When the transaction matures, the Fed returns the collateral and charges the primary dealer’s reserve account for the principal and accrued interest. A primary dealer are banks who directly trade with the Fed. In some cases the Fed will sell a security in exchange for reserves and upon maturity, reverse the transaction. This is known as a reverse repo. 

Another way the Fed implements its monetary policy is through discount lending. This involves the Fed lending to commercial banks.
The Fed implements discount lending to ensure short run stability in US financial markets. “The discount rate is the interest rate banks pay when borrowing at the Federal Reserve's discount window.”
There are three types of loans that can be made by the Fed. Primary credit, secondary credit and seasonal credit.
Primary credit ensures adequate liquidity in the banking system; it is a backup source of short-term funds for sound depository institutions.
Primary credit is a short term loan, usually overnight, to depository institutions in sound overall condition to meet short-term, backup funding needs. Interest is charged at 50 basis points, down from a 100 basis points, above the federal target rate since August 17, 2007.

Secondary credit is rare as it’s only granted when banks are in danger of collapsing. Institutions apply for secondary credit when they are not eligible for primary credit. Eligible institutions must execute the necessary documentation and pledge collateral to the Federal Reserve. A bank may choose to apply for secondary credit if there is a temporary shortfall in reserves, but this highly unusual. When an institution borrows from the Fed, it is because they cannot borrow from any other bank and by paying the secondary discount rate it is signalling to the rest of the market that it is in serious trouble.
The secondary credit market is better suited for financial institutions that are having long term issues that can be solved without them being liquidated. The fed will only lend money on the secondary credit market if it believes the bank has a good chance of surviving.

The final type of loan is called seasonal credit “and is aimed at relatively small institutions experiencing seasonal swings in borrowing needs, like banks in farm communities.” 

Another monetary policy tool that is implemented by the Fed is Reserve Requirements. “The Federal Reserve Board has had the authority since 1935 to set the reserve requirements.” The reserve requirement is a  that sets the minimum  each  must hold to customer . These reserves are designed to satisfy withdrawal demands, the reserve must be held either as vault cash or on deposit at the Fed.
The depository institution's reserve requirement is determined by applying the reserve ratios specified in the Federal Reserve Board's Regulation D to an institution's reservable liabilities (see table of reserve requirements). Reservable liabilities consist of net transaction accounts, non-personal time deposits, and eurocurrency liabilities. Since December 27, 1990, non-personal time deposits and eurocurrency liabilities have had a reserve ratio of zero.

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Finally the last monetary policy the Fed implements is Term Auction Facility. This is a relatively new tool the Fed uses, which was created in light with the credit crunch. It was first instated as a temporary policy on 21st December 2007.
Term Auction Facility, enables the Fed to auction a set amount of funds to depository institutions, against a wide range of collateral. Auctions held on December 17th and December 20th 2007 released $20 billion each in the form of 28- and 35-day loans, respectively.  The Fed is using the TAF as a trial of this type of monetary tool. Depending on its success and usefulness, the Fed may begin to use it as part of a more permanent program.

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Financial intermediaries and financial markets prime role is to provide a system to transfer and allocate funds to their most beneficial opportunities. “Financial intermediaries are agents, or groups of agents who are delegated the authority to invest in financial assets. In particular, they issue securities in order to buy other securities” 

A bank is a financial intermediary whose fundamental activity and main reason for existence is to take deposits from customers who posses’ surplus funds and lend these funds to customers and corporations that want to borrow funds.

There are 5 theories that explain why banks exist.

One of the main theories of why banks exist discusses the role of banks as “monitors” of borrowers. This is known as delegated monitoring. This function involves banks to collect and analyse information about the investments and obligations of borrowers to evaluate their ongoing creditworthiness for their own risk management purposes and as a supplement to risk management by their borrowers.

Monitoring credit risk can be very costly for the individual depositor and very inefficient for every depositor to carry out a credit risk check on every borrower, hence it makes economic sense to delegate this task to banks that have expertise and economies of scale in processing information on the risk liability of borrowers.

Secondly, banks exist to produce information on borrowers. Information on possible investment opportunities is not free, so economic agents may find it worthwhile to produce this information. However if individual lenders attempted to carry out this operation of gathering information they would incur significant costs and duplication of information. It could be a waste of resources if the lender discovered that the borrower is a high risk credit liability and decided not to lend after occurring costs.

Alternatively, banks can produce this information. Banks are able to gather this information. Realistically banks will gather information on borrowers overtime through repeated business. Even with this knowledge, the bank can never have full information on borrowers’ complete financial situation and ability to service its debt. This information is held solely by the borrower. As banks accumulate knowledge on borrowers’ credit risk, surplus unit individuals will place funds in banks with the knowledge that the funds will be allocated to creditworthy borrowers.

In addition to improving the flow and quality of information, banks provide financial or secondary claims to savers, which often have superior liquidity attributes compared to primary securities such as corporate equity and bonds.
Banks offer contracts that are highly liquid and low risk to savers on the liability side of the balance sheet whilst holding relatively illiquid and high risk assets. Banks achieve this through diversifying their risks and exploit the law of large numbers in this way, whereas savers are constrained to hold relatively undiversified portfolios. The potential fragility of banks is financing long term assets (eg loans) through short term deposits, as banks are exposed to the possibility that a large number of depositors will decide to withdraw their money.
Liquidity transformation makes banks vulnerable to “runs” (the possibility that many depositors will simultaneously withdraw large amounts of money due to the possibility of banks defaulting). Possibility of a run makes intermediation costly and banks need to maintain more reserves.  

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