Policies established in response to the financial crisis have altered the structure of the federal funds market in profound ways, says Cleveland Fed economist

Before the financial crisis, the federal funds market was one in which domestic commercial banks with excess reserves would lend funds overnight to other commercial banks with temporary shortfalls in liquidity. Now, says Federal Reserve Bank of Cleveland economist Ben Craig, government-sponsored enterprises such as the Federal Home Loan Banks lend funds in the fed funds market, and foreign commercial banks borrow to make money from interest paid on excess reserves. Craig says this can complicate the link between a federal funds policy and the real economy.

Describing the three developments that caused most of the change in the structure of the federal funds market, Craig says:

• The introduction of quantitative easing programs by the Fed flooded the banking system with liquidity and made it less necessary for banks to borrow in the fed funds market. Craig notes that the cash assets of domestic commercial banks increased by 467.4 percent between 2007 and 2016.
• To comply with the Dodd-Frank Act, the Federal Deposit Insurance Corporation (FDIC) introduced new capital requirements that increased the cost of wholesale funding for domestic financial institutions. Craig says the FDIC changed how its charges for insurance are calculated from being based on a bank’s deposits to being based on its assets. Because cash holdings are part of assets, Craig says the cost of holding cash received through borrowing on the interbank market is costlier now by 2.5 to 4 basis points. He notes that foreign banks usually do not have US deposits to insure and do not incur this cost.
• The Fed now pays some financial institutions interest on their excess reserves (IOER). In this environment, says Craig, “The institutions willing to lend in the federal funds market are those whose reserve accounts at the Fed are not interest-bearing, because the interest gained in such overnight lending is less than the IOER. These include government-sponsored entities (GSEs) such as the Federal Home Loan Banks. The institutions willing to borrow are those that do not face the FDIC’s new capital requirements and do have interest-bearing accounts with the Fed. These include many foreign banks.”

According to Craig, the decreased role of domestic institutions and increased role of foreign institutions in the federal funds market has made the link between a federal funds policy and the real economy more complex. “Making interest rate increases neutral -- in the sense of not inducing massive institutional shifts – while still changing the rate at which banks lend to each other is harder now,” says Craig.

Read The Federal Funds Market since the Financial Crisis

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.218.1892