Relationships Matter: The Importance of Relationships in the Fed Funds Market
Posted: 19 Mar 2011 Last revised: 25 Oct 2011
Date Written: March 15, 2011
We examine the relevance of search costs and the transmission of liquidity shocks in the US overnight interbank market. There is large and persistent heterogeneity in how banks form borrowing relationships in this market: while some banks mainly rely on spot transactions, most form stable borrowing relationships with at least one lender. These lenders tend to be in the same state as the borrower, but their business is less likely to be correlated with the borrower’s. We find that borrowers pay lower prices and borrow more from their relationship lenders. To assess the importance of search frictions, we exploit idiosyncratic demand shocks and exogenous supply shocks. Borrowers appear to increase borrowing from their most concentrated lenders on days when they idiosyncratically demand more funds, without paying significantly higher prices. Thus idiosyncratic demand shocks are not transmitted to the rest of the market (there is no impact on the market wide interest rate or liquidity). In contrast, exogenous shocks to the supply of liquidity as proxied for by days with low GSE lending lead to a market wide drop in liquidity and a rise in interest rates. However, borrowers with lending relationships are able to insulate themselves almost completely from the shock. This suggests that search costs are relatively more important than bargaining in this market.
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