Precautionary Reserves and the Interbank Market

55 Pages Posted: 22 May 2009

See all articles by Adam B. Ashcraft

Adam B. Ashcraft

Federal Reserve Bank of New York

James McAndrews

Wharton Financial Institutions Center

David R. Skeie

University of Warwick - Warwick Business School

Multiple version iconThere are 2 versions of this paper

Date Written: May 2009

Abstract

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 data on intraday account balances held by banks at the Federal Reserve and Fedwire interbank transactions to estimate all overnight fed funds trades, we present empirical evidence on banks’ precautionary hoarding of reserves, their 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. Our theoretical results show that banks rationally hold excess reserves intraday and overnight as a precautionary measure against liquidity shocks. Moreover, the intraday fed funds rate can spike above the discount rate and crash to near zero. Apparent anomalies during the financial crisis may be seen as stark but natural outcomes of our model of the interbank market. The model also provides a unified explanation for several stylized facts and makes new predictions for the interbank market.

Keywords: Tax law, S corporations, organizational form, dividend policy, sell-offs, industry structure

JEL Classification: G21, G10, E40, D53

Suggested Citation

Ashcraft, Adam B. and McAndrews, James and Skeie, David R., Precautionary Reserves and the Interbank Market (May 2009). FRB of New York Staff Report No. 370, Available at SSRN: https://ssrn.com/abstract=1407252 or http://dx.doi.org/10.2139/ssrn.1407252

Adam B. Ashcraft (Contact Author)

Federal Reserve Bank of New York ( email )

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New York, NY 10045-0001
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James McAndrews

Wharton Financial Institutions Center ( email )

2306 Steinberg Hall-Dietrich Hall
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19104 (Fax)

David R. Skeie

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

HOME PAGE: http://www.wbs.ac.uk/about/person/david-skeie

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