Commercial Banks in the Federal Funds Market

Commercial banks and other depository institution must hold liquid assets in a special reserve account, equal to a fraction of the funds deposited with them by the public. Only vault cash held on the premises and reserve balances kept with the Federal Reserve Bank in the district count in meeting this legal reserve requirement. Frequently, commercial banks (especially small banks) hold more legal reserves than the law requires, Because these reserve earn little r no income, most bankers active in the money market try to dispose of any excess legal reserves in their possession, even if they can only lend the funds overnight.
Banks are aided greatly in this endeavor by the fact that their legal reserve requirement is calculated on an average basis over a week. the reserve requirement is stated as a daily average for seven days stretching from Thursday to the following Wednesday, Moreover, Federal Reserve regulations allow the manager of the individual bank‘s money desk-the department responsible for keeping tract of the bank‘s legal reserve position-to base the current week‘s legally required reserve holdings on the level of deposits prevailing two weeks earlier. Current Federal Reserve regulations also permit the money desk manager to use the amount of vault cash held two weeks before to satisfy a portion of the current week‘s reserve requirement.
because the amount of vault cash is known in advance, the money manager‘s key problem is to adjust the Bank‘s reserve balances held at the Fed to the right level. That is,
Required reserves for a bank this week - Vault cash holdings of two weeks ago= required average daily deposits held at the Federal Reserve this week
Each week the money desk manager will try to make sure that the bank‘s average deposit balances at the Fed hits or comes close to this required level. the Federal fund market is an indispensable tool for this kind of daily reserve management, especially for the largest and most aggressive banks, which hold few reserves of their own. the majority of Federal funds transactions are 24-hour (overnight) loans to cover reserve deficiencies. There is a trend in the market, however, toward longer-term Fed funds loans for banks and other depository institutions with "permanent" reserve needs. Indeed, many large U.S. banks today borrow virtually their entire reserve requirement on a more-or-less-permanent basis from the Federal funds market