Can the US Interbank Market be Revived?

Large-scale asset purchases by the Federal Reserve as well as new Basel III banking regulations have led to important changes in U.S. money markets. Most notably the interbank market has essentially disappeared with the dramatic increase in excess reserves held by banks. We build a model in the tradition of Poole (1968) to study whether interbank market activity can be revived if the supply of excess reserves is decreased sufficiently. We show that it may not be possible to revive the market to pre-crisis volumes due to costs associated with recent banking regulations. Although the volume of interbank trading may initially increase as excess reserves continue to decline, the new regulations may engender changes in market structure that result in interbank trading being completely replaced by non-bank lending to banks when excess reserves become scarce. This non-monotonic response of interbank trading volume to reductions in excess reserves may lead to misleading forecasts about future fed funds prices and quantities when/if the Fed begins to normalize their balance sheet by reducing excess reserves.