On US banks
- they pay interest on deposits from customers and either borrow out the money to lenses or purchase short term US treasury . The spread between deposit interest rate paid to customers and US treasury yield/loan interest rate charged to lender is their profit
- they charge lenders interest above long term treasury yield rate and finance the loan through either their own deposits or from borrowing
- US Banks with deposits above USD122.3million needs to meet minimum reserve requirements of 10% imposed by the Federal reserve as of 2018
Meeting minimum reserve requirements
- Borrow from Federal Fund Rate based on central bank interest rates
Used within US economy
- rates are higher
- hassle free
- The federal funds rate is set in U.S. dollars and
- charged on overnight loans.
- The fed funds rate is the interest rate at which commercial banks in the US lend reserves to one another on an overnight basis
- London Interbank Offered Rate (LIBOR) -
Used internationally
- Borrow from other banks
- rates are lower based on global supply and demand equilibrium
- based on USD, EURO, Sterling, Swiss Franc, Yen
- Quotations:
overnight, one week, and
- one, two, three, six, and 12 months.
Federal reserve debt structure
- US treasury bills:
short term maturity at one year or less.
- Sold at discount
- paid fully at maturity
- US treasury notes:
1 year to 9 years maturity
- Sold at face value
- pays fixed interest rates every six months.
- Sold auction style.
- US treasury bonds:
10 years to 30 years maturity.
- Sold at face value and
- pays fixed interest rates every six months .
- The original vehicle.
- Registered to single owner and cannot be resold.
Federal Interest rate hike
- Long term interest rate tend to react faster to hikes then short term interest rates
- Long term Federal interest rates are used as benchmarks by banks to determine interest to charge lenders.
- To prevent hyper inflation (price stability) after all employable people within the country have been employed into the economy.
Understanding the yield curve
- Interest rates are considered the cost of money
- The Federal reserve only manipulates the overnight interest rate
- Longer term interest rates are determine by demand and supply of money
- The Federal reserve increases the overnight interest rate by reducing the supply of money in circulation. This is achieved by supplying more short term securities in the open market, .
- The Federal reserve decreases the overnight interest rate by increasing the supply of money in circulation. This is achieved by buying up short term securities in the open market.
- Long term interest rates are higher than short term interest rates because long term interest rates require you to endure greater interest-rate uncertainty as well as greater likelihood of government default
Related readings
- [Understanding treasury yield and interest rates](https://www.investopedia.com/articles/03/122203.asp)
- [Understanding US bonds, notes and bills](https://www.investopedia.com/ask/answers/difference-between-bills-notes-and-bonds/)
- *The bank credit analysis handbook*, Jonathan L. Golin and Philippe Delhaise