Fed Notes: Bank-to-Bank Fed Funds Lending Signals Liquidity Stress
A Federal Reserve note says bank-to-bank fed funds trades reveal liquidity distribution frictions that aggregate reserve measures miss, especially as reserves decline.
What you need to know
A Federal Reserve FEDS Note argues that fed funds market activity retains diagnostic value for bank liquidity. Lending between domestic banks, rather than arbitrage by non-bank lenders, is highly sensitive to lenders' reserve positions and can signal distributional stress even when aggregate reserves appear ample.
- Federal Home Loan Banks provide over 90% of fed funds lending, while U.S. branches of foreign banks account for about 90% of borrowing volume.
- Bank lenders' supply elasticity nearly doubles from 0.15 at high reserve levels to about 0.30 at the lowest observed reserve ratio.
- A $10 billion rise in weekly demand deposits at small domestic banks is associated with a 77% increase in fed funds borrowing from bank lenders and a 16 basis point rate increase.
Market structure and information content
The note, by Sriya Anbil, Sebastian Infante and Zeynep Senyuz, says the fed funds market changed after the 2008 crisis. Non-bank lenders, mainly Federal Home Loan Banks, now dominate lending, while U.S. branches of foreign banks do most borrowing to earn the spread to interest on reserve balances.
Because those arbitrage trades respond little to bank liquidity, the authors say they carry limited information. Domestic banks instead borrow mainly to meet liquidity needs, and their trades are more sensitive to reserve distribution.
Elasticity and smaller banks
The research finds bank lenders supply reserves inelastically, while non-bank lenders supply elastically. Bank lender elasticity rises from 0.15 at high reserve levels to about 0.30 at the lowest observed reserve ratio, the note says.
Small domestic banks show greater sensitivity to deposit outflows. A $100 increase in weekly deposits at small institutions is associated with a $16 increase in reserves, a larger response than at bigger banks.
Policy monitoring
The authors argue aggregate reserve measures can mask distributional frictions, and that bankers' banks offer additional signals about smaller institutions. They say the market's diagnostic role is likely to grow if reserves decline.
Why does bank-to-bank fed funds lending matter more than non-bank arbitrage?
The note says bank lenders supply reserves inelastically and their rates are sensitive to reserve positions, so their trades reveal distributional liquidity stress that non-bank arbitrage activity does not.
Sources & context
- Ripples in the Reserve Pool: Unveiling Liquidity Signals from the Federal Funds Market - FEDS Notes ↗federalreserve.gov
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