Question

What is the federal funds market? How does it help banks strike a balance between liquidity and profitability?

Answer 1

Federal funds market is the market in which banks can borrow or lens reserves, allowing banks temporarily short of their required reserves to borrow reserves from banks that have excess reserves. Generally the federal bank lends money. Federal funds are overnight borrowings between banks and other entities to maintain their bank reserves at the federal reserve.

For example the loan market is in high demand and bank A is short of funds. 'A' can then borrow money to give away loans which will eventually be profitable in future as they start to receive interest. Thus by borrowing right amount, banks can strike a balance between liquidity and profitability.

Profitability and Liquidity are two basic concepts that attract the attention of all banks. Given the position of banks as catalyst to economic development, they cannot afford to fail their customers nor the public in any of these two issues.Banks want to make profits but at the same time they are concerned about liquidity and safety. Banks have to earn profits because if they don’t, they would not work at all, as the shareholders would withdraw their invested capital in the business if proper and adequate dividends are not earned. Hence they have to earn profits for their shareholders and at the same time satisfy the withdrawal needs of its customer. in order to remain profitable in business, banks must give out loans facilities from their deposit liabilities, at a reasonable interest charges. Banks therefore make the buck of their declared profits through financial intermediation. The proper use of liquidity brings about profitability. A bank must be socially responsible in the pursuit of profit to create goodwill for itself, hence repeat purchases of its products by confident customers and prospects alike. There must therefore be a balancing of profitability with customer satisfaction through excellent services delivery strategies.

The major role of banks is to collect money from the public in the form of deposits and then along with its own funds to serve the demands of the customers quickly, paying interest for the deposits and to meet out the expenses to carry out its activities. For this purpose, banks maintain adequate liquidity and earn profits from its activities. Profit is the main reason for the continued existence of every commercial organization and profitability depicts the relationship of the absolute amount of profit with various other factors. In any case, compared to other business concerns, banks in general have to pay much more attention for balancing profitability and liquidity. Liquidity is required to meet out the prompt demands of customers and profitability is required to meet out the expenses of banks. But both the terms are contradictory in nature. If banks maintain more liquidity, their profitability decrease and if they increase their profitability they will have to reduce their liquidity. In this way, banks act as an engine for a business organization.