tive in identifying good and creditworthy borrowers. Otherwise, in case of aggressive and careless lending, they realize that they may lose their capital if loans turn out bad. Another safeguard is deposit insurance provided by the CB or an agency (FDIC in the U.S- Federal Deposit Insurance Corporation)Sometimes, banks may run into temporary liquidity problems (less serious than insolvency) when the required reserves and excess reserves can not cover the deposit withdrawals. Or they may simply need more funds (than made available by the depositors) to take advantage of good investment opportunities (loans?). At the extreme case of a liquidity crisis, depositors may run into a bank to withdraw funds when they lose confidence in the ability of banks to make payments (A Bank Panic and A Bank Run). In such cases, there are three major options available to banks. 1) They can borrow from the CB, a lender of last resort, through the discount window it operates. The discount rate is the rate the CB charges ion loans to the banking sector. 2) They can borrow from other banks in the interbank market, called the federal funds market in the U.S. at the interbank interest rate (or the federal funds rate in the U.S.). Banks with excess funds may choose to lend to others who happen to be short of funds that day, say, due to unexpected withdrawals. Higher the interbank (as well as the discount rate charged by the CB), more difficult and costly is to borrow for banks. Hence, banks, in a time of rising interbank and discount rates, try to prepare for unusual deposit withdrawals and investment opportunities by holding more excess reserves, behaving prudently. 3) They can directly sell part of their government bond holdings in the g-bond market or enter into a repo (repurchase agreement- when a bank borrows on a very short-term basis (1 day/ a week/ a month by selling g-bonds with the promise of purchasing them back at a higher price at the end of the m...
