Reserve balances, the federal funds market and arbitrage in the new regulatory framework

We study demand for reserves and trading dynamics in the federal funds market in the context of two banking regulatory changes: the widening of the FDIC assessment base and the introduction of the Basel III regulatory ratios. Using a novel panel of FDIC fee rates, we show that the widening of the assessment base changed the relative funding costs and incentives for banks to hold reserves. We document that foreign banks, not subject to the FDIC fee, experienced positive conditions for arbitraging between borrowing funds in the federal funds market and holding those funds in their reserves accounts to earn interest on excess reserves. As a result, foreign banks increased their reserve holdings and federal funds borrowing relative to domestic banks, contributing to a change in the distribution of reserves in the banking system and in the composition of banks’ balance sheets. Furthermore, we find that since the implementation of the Basel III leverage ratio, foreign banks have engaged in window dressing, with reserves and federal funds borrowing temporarily declining on reporting days. We introduce a model that incorporates the new regulatory framework and derive testable hypotheses to support our findings. Results suggest that: 1) following the implementation of the FDIC rule, the share of reserves over assets held by domestic banks was 4.5 percentage points lower than the share held by foreign banks. 2) after the public disclosure of the Basel III leverage ratio, foreign banks’ reserves on reporting dates relative to the period average dropped by 18.3 percentage points compared to domestic banks.