Business Glossary

sale of securities coupled with an agreement to repurchase the securities at a higher price on a later date. A repurchase agreement is similar to a secured loan. Most repurchase agreements (or repos, as they are called) are overnight transactions, with the sale taking place one day and repurchase the next. Long-term repos, or term repos, can extend for a month or more, usually for a fixed time period. The opposite side of a repurchase agreement is a reverse repurchase agreement, a purchase of securities followed by a sale back to the seller. Securities dealers use repurchase agreements to finance their inventories, selling their inventories to counterparty investors (for instance, a money market mutual fund) that have excess short-term funds they want to invest in higher-yielding securities.

An innovation in repo trading by the Fixed-Income Clearing Corporation, first introduced in 1998, allows dealer firms to freely trade general collateral repos-the most widely traded type of repurchase agreement-throughout the day without intraday trade-for-trade settlement, adding greater efficiency to the repo market. Securities eligible for trading include Fannie Mae and Freddie Mac fixed-rate mortgage backed securities and U.S. Treasury bills, notes, and bonds.

portion of their deposits banks and savings institutions are required to maintain as legal reserves for the protection of depositors. Reserve requirements also provide one of the monetary adjustment tools the Federal Reserve System employs to regulate the supply of credit in the banking system. By raising or lowering the amount of required reserves, the Federal Reserve can either stimulate or tighten available bank credit, and the ability of banks to lend-known as fractional reserve banking. The ratio of required reserves to deposits ranges from 3% to 12% for transaction accounts such as checking accounts and Negotiable Order of Withdrawal (NOW) accounts, and up to 3% for time deposits (certificates of deposit). The reserve requirement may be kept in a separate checking account or with the bank's own cash (vault cash). Commercial banks that are member banks in the Federal Reserve System are required to maintain their reserves in a checking account (reserve account) at the nearest Federal Reserve Bank. Other financial institutions have the option of holding reserves at a Federal Reserve Bank or in a checking account (called a pass-through account) at a correspondent bank.

purchase or sale of government securities by the Open Market desk at the Federal Reserve Bank of New York, as directed by the Federal Open Market Committee.

By buying and selling securities, mostly short-term Treasury obligations,i.e., Treasury bills, the Federal Reserve is able to: (1) meet the public demand for cash by adjusting bank reserves upward or downward, as needed, and (2) influence bank interest rates, including rates such as the Federal Funds (Fed Funds) rate that banks charge for short-term sale of excess reserves. Because reserve accounts at Federal Reserve Banks don't earn interest, banks try to hold reserves to a minimum or to the level of required reserves.

When the manager of the Fed's Open Market Desk at the Federal Reserve Bank of New York makes the decision to buy securities, the Fed writes a check on itself to the bank, or other institutional investor holding the securities, and deposits a check in a commercial bank. If the Fed buys $1 billion in Treasury bills, bank reserves are increased by that amount. Selling $1 billion in T-bills has the opposite effect, shrinking the reserves in the banking system, which tends to drive up the cost of credit, and interest rates. Because commercial bank reserve accounts don't earn any interest, banks try to hold their reserves at a minimum. When the Fed is worried that the inflation rate is rising, it pursues a tight money policy by selling securities. What results is higher interest rates, because the banks pass the added cost along to the borrowers.

The Fed also adds reserves to the banking system to meet the public's seasonal demand for cash. This demand for cash varies seasonally; it is highest in December, and lowest in late summer.

For these reasons, open market operations are the most flexible monetary tool the Fed has available in implementing its monetary policy objectives. Because commercial banks have about three-fourths of the nation's checking account deposits, the Fed, by managing the level of reserves in the banking system, is able to influence the nation's supply of money (the money supply or money stock), and the cost of credit. Both the Fed Funds rate, which is the market rate banks pay one another for nonborrowed reserves, and the bank prime rate are influenced to a large degree by the Fed's actions in open market operations.

Other tools of monetary policy are the discount rate and reserve requirements.

place in the Federal Reserve where banks go to borrow money at the discount rate. Borrowing from the Fed has been a last resort for banks short of reserves, but in mid-2002, the Fed proposed encouraging direct loans to reduce volatility in the federal funds rate. Banks would be expected to use the "window" when Fed funds exceeded the Fed's target rate.