Question

The crisis of 2008 spurred some changes in how the Federal Reserve interacts with banks. For one, it started paying interest on reserves held with the bank. For another, it changed the rules to make "daylight overdrafts" more difficult. A daylight overdraft is when a bank's balance at the Fed goes negative during the day but is brought back to positive by the close of business.

How would these changes affect a bank managing liquidity risk on its balance sheet?

Answer 1

Introduction:-

The Financial Crisis in 2008, was primarily because of the fact that banks gave away loans to people much easier than they should have without assessing the quality of the asset being pledged which in this case was real estate. Thus, when the demand for real estate went down, banks were unable to sell the pledged assets and had to incur huge losses which required active government intervention to be corrected.

The Federal bank then came up with stringent techniques to increase the liquidity of the banks meaning the amount of asset available to it as reserves in the short and long run so that these problems do not occur again in the system.

How these changes effect the banking system are as explained.

Case Specifics:-

The banking sector directly operates on margin requirements which are set by the Federal Bank. These represent a percentage of deposits with the banks which have to be mandatorily kept within the bank and cannot be given away as loans.

The deposits which people make into their accounts serves as profit making tool for banks as it allows them to generate money by giving away loans.

By increasing the norms which disallow a bank to give away more than loans than the margin requirements safeguards the bank and the overall economy from financial shocks. This is because the banks then cannot provide loans in excess.

Daily overdrafts is a feature in which a bank overuses the money and pays back to the federal bank in a few days or on the same day, With the federal bank having stricter norms for the same, banks are unable to give away excess loans which may be a problem in the long run. This increases the liquidity of the banks as they have to hold their cash reserves constant.

Further, they are also provided incentives of interest rates which the federal banks provide them if they maintain their cash with the federal bank. This allows banks to have excess reserves which earn them revenue without it being loaned out. This further decreases their liquidity risk as banks have reserves in excess.

Please feel free to ask your doubts in the comments section if any.