Discipline and Liquidity in the Market for Federal Funds

Abstract

I find that high-risk banks pay more for federal funds and are less likely to utilize them as a source of liquidity. The extent of this discipline has risen in recent years, following legislation designed to impose more of the costs of bank failure on uninsured creditors. However, the risk-pricing remains imperfect, and additional results suggest that information problems persist in the fed-funds market. The findings have implications for interest-rate determination, risk contagion in the financial system, the use of market data in banking supervision, and recent efforts to reform Discount Window operations.

Keywords: Market Discipline, Federal Funds, Liquidity, Bank Risk, Discount Window

JEL Classification: E40, G14, G21, G28