Un-Networking: The Evolution of Networks in the Federal Funds Market

Abstract

Using a network approach to characterize the evolution of the federal funds market during the Great Recession and financial crisis of 2007-2008, we document that many small federal funds lenders began reducing their lending to larger institutions in the core of the network starting in mid-2007. But an abrupt change occurred in the fall of 2008, when small lenders left the federal funds market en masse and those that remained lent smaller amounts, less frequently. We then test whether changes in lending patterns within key components of the network were associated with increases in counterparty and liquidity risk of banks that make up the core of the network. Using both aggregate and bank-level network metrics, we find that increases in counterparty and liquidity risk are associated with reduced lending activity within the network. We also contribute some new ways of visualizing financial networks.

Keywords: Banks, credit unions, and other financial institutions, Counterparty credit risk, Data visualization, Network models

JEL Classification: G2, E5