Rodney Garratt, Antoine Martin, and James McAndrews at the New York Fed have a very nice post, Turnover in Fedwire Funds Has Dropped Considerably since the Crisis, but It’s Okay.
Before the crisis, banks held about $50 billion of reserves at the Fed. That's not a lot of money. When banks want to pay each other -- say you write a check to me, so my bank has to get money from your bank -- they do it by transferring reserves through the Fedwire. So, that's why banks keep some reserves there.
But $50 billion is tiny compared to $10 trillion of M2, and banks use reserves to clear financial transactions too. A huge amount must flow by passing around these tiny reserves. How did banks do it? What happens if bank B says to bank A, "send us $10 million" and bank A didn't have $10 million left at that second in reserves?
Answer: "intraday overdrafts." The Fed would lend bank A the $10 million -- just flip a switch and put $10 million in their reserve account, and call the loan an asset corresponding to this liability. A then pays B, and works hard to make sure that it collects $10 million from C and D by the end of the day.
|Source: Rodney Garratt, Antoine Martin, and James McAndrews at the New York Federal Reserve|