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A model of stigma in the fed funds market

  • Weinberg, John A.
  • Ennis, Huberto M.

It is often the case that banks in the US are willing to borrow in the fed funds market (the interbank market for funds) at higher rates than the ones they could obtain by borrowing at the Fed's discount window. This phenomenon is commonly explained as the consequence of the existence of a stigma effect attached to borrowing from the window. Most policymakers and empirical researchers consider the stigma hypothesis plausible. Yet, no formal treatment of the issue has ever been provided in the literature. In this paper, we fill that gap by studying a model of interbank credit where: (1) banks benefit from engaging in intertemporal trade with other banks and with outside investors; and (2) informational frictions limit those trade opportunities. In our model, banks obtain loans in an over-the-counter market (involving search, bilateral matching, and negotiations over the terms of the loan) and hold assets of heterogeneous qualities which in turn determine their ability to repay those loans. When asset quality is not perfectly unobservable by outside investors, information about the actions taken by a bank in the credit market may influence the price at which it can sell its asset. In particular, under some conditions, discount window borrowing may be regarded as a negative signal about the quality of the borrower's assets. In such cases, some of the banks in our model, just as in the data, are willing to accept loans in the interbank market at higher rates than the ones they could obtain at the discount window.

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Paper provided by Universidad Carlos III de Madrid. Departamento de Economía in its series UC3M Working papers. Economics with number we095937.

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Date of creation: Sep 2009
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Handle: RePEc:cte:werepe:we095937
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  1. Xavier Freixas & José Jorge, 2007. "The role of interbank markets in monetary policy: A model with rationing," Economics Working Papers 1027, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 2008.
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  4. Ricardo Lagos & Guillaume Rocheteau, 2007. "Liquidity in asset markets with search frictions," Working Paper 0706, Federal Reserve Bank of Cleveland.
  5. Freixas, X. & Holthausen, C., 2001. "Interbank Market Integration under Asymmetric Information," Papers 74, Quebec a Montreal - Recherche en gestion.
  6. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank liquidity, interbank markets and monetary policy," Economics Working Papers 1202, Department of Economics and Business, Universitat Pompeu Fabra.
  7. Douglas W. Diamond & Raghuram G. Rajan, 2009. "Fear of Fire Sales and the Credit Freeze," NBER Working Papers 14925, National Bureau of Economic Research, Inc.
  8. Furfine, Craig, 2003. "Standing Facilities and Interbank Borrowing: Evidence from the Federal Reserve's New Discount Window," International Finance, Wiley Blackwell, vol. 6(3), pages 329-47, Winter.
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  10. Acharya, Viral V & Gromb, Denis & Yorulmazer, Tanju, 2008. "Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking," CEPR Discussion Papers 6984, C.E.P.R. Discussion Papers.
  11. Leonardo Bartolini & Svenja Gudell & R. Spence Hilton & Krista B. Schwarz, 2005. "Intraday trading in the overnight federal funds market," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 11(Nov).
  12. Furfine, Craig, 2002. "The interbank market during a crisis," European Economic Review, Elsevier, vol. 46(4-5), pages 809-820, May.
  13. Hayne E. Leland and David H. Pyle., 1976. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Research Program in Finance Working Papers 41, University of California at Berkeley.
  14. Heider, Florian & Hoerova, Marie & Holthausen, Cornelia, 2010. "Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk," CEPR Discussion Papers 7762, C.E.P.R. Discussion Papers.
  15. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
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  17. 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.
  18. Furfine, Craig H., 2000. "Interbank payments and the daily federal funds rate," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 535-553, October.
  19. Ricardo Lagos & Randall Wright, 2002. "A unified framework for monetary theory and policy analysis," Working Paper 0211, Federal Reserve Bank of Cleveland.
  20. Patrick Bolton & Tano Santos & Jose A. Scheinkman, 2011. "Outside and Inside Liquidity," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 259-321.
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  23. Kim, Youngse, 2003. "Income distribution and equilibrium multiplicity in a stigma-based model of tax evasion," Journal of Public Economics, Elsevier, vol. 87(7-8), pages 1591-1616, August.
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