Saturday, February 20, 2010

Fed Rates

I'd just like to quickly comment on the distinction between the Discount Rate, which was increased Thursday, with the Federal Funds Rate, which is the more prominent interest rate policy and remains unchanged at zero percent.

The "Federal Funds Rate" or "Overnight Rate" is a necessary fudge factor in a system of fractional reserve lending, where banks have only a small percentage of cash on hand to cover their deposits. If there are substantial withdrawals or loans, and reserves dwindle, they have quick access to cash through the Federal Funds Rate. Getting money from the Fed in this way is ordinary, everyday business.

The "Discount Rate" is a longer term loan when banks find themselves generally undercapitalized and need emergency money to weather adverse circumstances—like say more loans going bad than tolerance limits allow. In these circumstances banks are mostly encouraged to seek loans from other banks to stay afloat. If they have to go to the Fed for this sort of loan, it casts a shadow of doubt. At least it used to. Bailout circumstances being the way they are, who knows, maybe no longer.

So, raising the Discount Rate will adversely affect the ability of struggling banks to survive. The likelihood of an FDIC seizure increases, and with that, opportunities for healthier banks to acquire the assets of seized banks at fire sale prices. Of course, at 0.75% the Discount Rate is still extremely low, but if the Fed wratchets it up in a step-wise fashion, this may be what we see.

UPDATE [2/23/10]: Today the FDIC reported a 27% increase in "problem" banks for the year 2009. If the discount rate keeps going up, as hopefully it will, it could be feeding time soon for the healthier banks.

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