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The first line of defense: the discount window during the early stages of the financial crisis

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  • Elizabeth Klee
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    Abstract

    This paper develops a theoretical model of trading in the federal funds market that captures characteristics of discount window borrowing and the federal funds market during the first year of the financial crisis, including the narrowing of the spread between the discount rate and the target rate; the increased incidence of high-rate trading; and the decline in participation in the federal funds market. The model shows that differences in stigma of borrowing from the discount window across banks can cause the federal funds rate to rise, even when the spread between the discount rate and the target rate narrows. The model is then evaluated using both aggregate and institution-level data. The data suggest that in aggregate, federal funds volume brokered at rates above the primary credit rate and discount window borrowing both increased during the first stages of the crisis. Bank-level data suggest that institutions that went to the discount window paid lower rates in the federal funds market than banks that did not. This effect became stronger as the spread between the primary credit rate and the target rate narrowed, coincident with the intensification of the financial crisis.

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    File URL: http://www.federalreserve.gov/pubs/feds/2011/201123/201123abs.html
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    File URL: http://www.federalreserve.gov/pubs/feds/2011/201123/201123pap.pdf
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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2011-23.

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    Date of creation: 2011
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    Handle: RePEc:fip:fedgfe:2011-23

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    Related research

    Keywords: Discount ; Federal funds ; Global financial crisis;

    This paper has been announced in the following NEP Reports:

    References

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    1. Stavros Peristiani, 1998. "The Growing Reluctance To Borrow At The Discount Window: An Empirical Investigation," The Review of Economics and Statistics, MIT Press, vol. 80(4), pages 611-620, November.
    2. Selva Demiralp & Erhan Artuc, 2009. "Provision of Liquidity through the Primary Credit Facility during the Financial Crisis: A Structural Analysis," 2009 Meeting Papers 215, Society for Economic Dynamics.
    3. Bartolini, Leonardo & Hilton, Spence & McAndrews, James J., 2010. "Settlement delays in the money market," Journal of Banking & Finance, Elsevier, vol. 34(5), pages 934-945, May.
    4. Humberto M. Ennis & John A. Weinberg, 2009. "A model of stigma in the fed funds market," Economics Working Papers we095937, Universidad Carlos III, Departamento de Economía.
    5. Anastasia Semykina & Jeffrey M. Woodridge, 2010. "Estimating Panel Data Models in the Presence of Endogeneity and Selection," Working Papers wp2010_10_01, Department of Economics, Florida State University.
    6. Morten L. Bech & Elizabeth Klee, 2010. "The mechanics of a graceful exit: interest on reserves and segmentation in the federal funds market," Finance and Economics Discussion Series 2010-07, Board of Governors of the Federal Reserve System (U.S.).
    7. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed not Frozen: The Fed Funds Market in the Financial Crisis," NBER Working Papers 15806, National Bureau of Economic Research, Inc.
    8. Gara Afonso & Anna Kovner & Antoinette Schoar, 2011. "Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis," Journal of Finance, American Finance Association, vol. 66(4), pages 1109-1139, 08.
    9. Selva Demiralp & Erhan Artuç, 2007. "Discount Window Borrowing after 2003: The Explicit Reduction in Implicit Costs," Koç University-TUSIAD Economic Research Forum Working Papers 0708, Koc University-TUSIAD Economic Research Forum.
    10. Daniel L. Thornton, 2008. "Walter Bagehot, the discount window, and TAF," Economic Synopses, Federal Reserve Bank of St. Louis.
    11. Wooldridge, Jeffrey M., 1995. "Selection corrections for panel data models under conditional mean independence assumptions," Journal of Econometrics, Elsevier, vol. 68(1), pages 115-132, July.
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