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Regulatory Requirements of Banks and Arbitrage in the Post-Crisis Federal Funds Market

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  • Rod Garratt
  • Sofia Priazhkina

Abstract

This paper explains the nature of interest rates in the U.S. federal funds market after the 2007-09 financial crisis. We build a model of the over-the-counter lending market that incorporates new aspects of the financial system: abundance of liquidity, different regulatory standards for banks, and arbitrage opportunities created by limited access to the facility granting interest on excess reserves. The model determines the equilibrium federal funds rate as a function of the policy rates and explains the “leaky floor” phenomenon in which we observe federal funds rates that are strictly below the interest rate paid on reserves. Using the model, we explain the impact of raising government yields and tightening the Liquidity Coverage Ratio (LCR) and the Supplementary Leverage Ratio (SLR) requirements on the federal funds rates.

Suggested Citation

  • Rod Garratt & Sofia Priazhkina, 2022. "Regulatory Requirements of Banks and Arbitrage in the Post-Crisis Federal Funds Market," Staff Working Papers 22-48, Bank of Canada.
    • Handle: RePEc:bca:bocawp:22-48
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    References listed on IDEAS

    as
    1. Simon M. Potter, 2018. "Confidence in the implementation of U.S. monetary policy normalization: remarks at the 23rd EMEAP (Executives’ Meeting of East Asia-Pacific Central Banks) Governors’ Meeting, Manila, Philippines," Speech 291, Federal Reserve Bank of New York.
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    6. Bech, Morten L. & Klee, Elizabeth, 2011. "The mechanics of a graceful exit: Interest on reserves and segmentation in the federal funds market," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 415-431.
    7. Kyungmin Kim & Antoine Martin & Ed Nosal, 2020. "Can the U.S. Interbank Market Be Revived?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(7), pages 1645-1689, October.
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    More about this item

    Keywords

    Central bank research; Economic models; Financial institutions; Financial markets; Financial stability; Financial system regulation and policies; Wholesale funding;
    All these keywords.

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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