I know there is more demand to hold money on the borrowers side right now, which should push interest rates down. But despite the dearth of people who currently want to borrow, banks still seem to feel there aren’t very many good loans to hand out and are instead choosing to collect .25% from the Fed.(at this point if I have gotten anything wrong please correct me.). If this is the case, why shouldn’t banks raise the interest rates to make lending worth their while since they are so often afraid to lend out money with the current very low interest rates?
There is one faulty step in your argument. Banks do not lend out their reserves. They hold them against their fiduciary issue. When conditions return to normal and banks begin to lend again, they will do so by issuing fiduciary media and creating credit not by lending out their reserves. In that way, the banks will earn 0.25 percent on their reserves and the market interest rate on their created credit.
The reason the banks are not issuing much additional fiduciary media nor creating much additional credit is that they are still liquidating the bad loans accumulated during the boom from their balance sheets. Given the fragility of financial markets, banks prefer to hold a larger portion of their assets as cash on their balance sheets instead of loans and securities.
So given the unusual demand and supply conditions, credit markets are clearing at the current low interest rates. If banks raised their rates, they would have excess supply of credit.