[MichaelConlon]

The cash reserve system was introduced to protect against a 1920's style bank run. The idea being that a bank should have enough liquid assets to cover 10 or 15% of their customers pulling all of their deposited funds out of the bank.

The goal of a bank is to make as much money as it can with it's assets. It's in the banks interest to loan out as much as it safely can while staying above the reserve requirements. If a bank were to dump it's assets to ensure it met reserve requirements it would likely sell at firesale prices which could drive down the price of those assets for the rest of the market. By taking a loan from the Fed and using those assets as collateral that scenario is avoided. It's also worth noting that these loans are not free, the Fed does charge interest.

So the bank avoids dipping below reserve requirements (and flooding the asset market) and the Fed earns a small amount of interest.

[apacheCamel]

I guess my question would be then why did the bank originally allow themselves to loan too much out? From what you said, it seems like they loaned too much out and without the Fed they would then have to dip into their assets to meet the regulation. So it still seems like the bank messed up and the Fed is bailing them out (despite with interest). I agree it would be a problem for them to dump the assets but it also seems like a problem they are in this situation to begin with.

[MichaelConlon]

You're correct in that it means that the bank messed up. The idea is that this is for (relatively) small amounts to cover reserve funds for a short period of time. This may happen because large deposit accounts decided to withdraw unexpectedly or loan repayments stopped coming in. Ideally this is to be used for a day or maybe a week. However, you're correct that there is certainly potential for abuse in the system if a bank is doing this repeatedly every day for months or more. I'm not sure what, if any, measures are in place to prevent that abuse.