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A few readers were commenting on the significance of the following and I have decided to throw my two cents in:

Non-borrowed Funds

As a result of increased counterparty risk inter-bank borrowings between the banks had dried up. In response, Federal Reserve (Fed), in December 2007, announced Term Auction Facility (TAF) to facilitate banks to borrow directly from Fed against a wide range of collaterals. The interest rate on the borrowing was decided to be determined through an auction process.

A plunge in non-borrowed reserves (total reserves minus borrowed reserves) since January 2008 has attracted a lot of attention in the financial community to argue if it signaled distress in the US banking system.

One would need to understand the flow of money to assess the underlying essence of transaction. The money was lent to banks, and for each dollar lent through the TAF the Fed was careful to liquidate a dollar of its holdings of Treasury bills and bonds to keep its overall balance sheet unchanged. The money borrowed by banks under TAF by Fed was classified as borrowed funds, the figure of which was subtracted from total reserves.

Essentially, it amounted to indirect lending by banks to each other through Fed. To understand clearly, please see the diagram below. Bank 2 borrows from Fed under TAF against collaterals. Fed sells an equal amount of Treasury bills to Bank 1 to raise an equal amount. As a result, the amount received from Bank 1 is being used to lend to Bank 2. The TAF didn’t add to the money supply in the economy as Fed liquidates its holdings of Treasury bills for amount of dollar lent through the TAF. The figure of negative non-borrowed reserves in Fed’s balance sheet is represented by issuance of treasuries and bonds to banks.


Intermediately role of Fed