Federal Funds

Federal funds, which the cool kids call “fed funds” for short, are the excess reserves that banks give to each other, or back to the Fed (a.k.a. the Federal Reserve), in the form of a loan. Fed funds are extra funds that are lent to banks that need the cash on hand to fulfill the legal reserve requirements.

Federal funds are loaned to banks at the federal funds (or “overnight”) rate, which is a (usually) low interest rate. Every day, all commercial banks have to make sure they have enough reserves on hand to meet federal reserve requirements.

For instance, if federal reserve requirements are 10%, banks must keep 10% of all money they have in deposits on hand...so a bank with $1,000,000 in deposits from their banking customers would need $100,000 in reserves on hand. If one bank has extra reserves and another bank is lacking the reserves it legally needs at the end of the day, the first bank will lend these “federal funds” to the second bank to help them fulfill their reserve requirements. Isn't that sweet?