Precautionary Reserves and the Interbank Market
54 Pages Posted: 22 Mar 2009
Date Written: December 5, 2008
Liquidity hoarding by banks and extreme volatility of the fed funds rate have been widely seen as severely disrupting the interbank market and the broader financial system during the 2007-08 financial crisis. Using a dataset of intraday Federal Reserve bank account balances and Fedwire interbank transactions to estimate all overnight fed funds trades, we show empirical evidence on banks' precautionary hoarding of reserves, reluctance to lend and extreme fed funds rate volatility. We develop a model with credit and liquidity frictions in the interbank market consistent with the empirical results. Banks rationally hold excess reserves intraday and overnight as a precautionary measure to self-insure against liquidity shocks. The intraday fed funds can spike above the discount rate and crash to near zero. Apparent anomalies during the crisis may be explained as the stark but natural outcomes of our general model of the interbank market. The model also provides a unified explanation for previously documented stylized facts and makes new predictions for the interbank market.
Keywords: excess reserves, fed funds market, discount window, large-value payments, limited participation
JEL Classification: G21, G28, E42, E58
Suggested Citation: Suggested Citation