Are Banks Really Making Short Term Loans to Other Banks for Zero Interest?

BY busadmin  December 18, 2008 at 12:33 PM EST

Question/Comment: When people speak of the Fed funds rate being zero, does that mean that banks are literally making short-term loans to other banks for NO INTEREST WHATSOEVER? Why would any bank do that, since there is some risk of non-repayment on any loan?

Paul Solman: Yes, the fed funds rate is the interest rate banks pay one another for overnight deposits to square their books, keeping up their legally required deposits with the Fed (roughly, 10 percent of their assets).

But right now, given that banks aren’t lending, my guess is that they have more than the required reserves on deposit with the Fed. Indeed, that’s what they’ve been doing with all the money the Fed has been pumping into them – re-depositing it at the Fed.

My further guess, then, is that banks don’t really need to lend much to each other these days. But if they DID, the reason they would consent to do so at zero interest is that if inflation is running even lower than that, they’re making money. In other words, say you, Carl, lend me $1 million dollars overnight. (This is okay, right? You know where to find me.) I pay you back tomorrow. But if there’s DEFLATION, that $1 million is actually worth MORE tomorrow than today. So why WOULDN’T you lend?

Editor’s Note: For a more historical look at reforms in the banking industry, you can watch a 1991 NewsHour segment on the subject below.