Can the U.S. Interbank Market Be Revived?
| Published date | 01 October 2020 |
| DOI | http://doi.org/10.1111/jmcb.12693 |
| Date | 01 October 2020 |
| Author | ED NOSAL,KYUNGMIN KIM,ANTOINE MARTIN |
DOI: 10.1111/jmcb.12693
KYUNGMIN KIM
ANTOINE MARTIN
ED NOSAL
Can the U.S. Interbank Market Be Revived?
The U.S. interbank market essentially disappeared as the reserve supply dra-
matically increased after the 2007–2008 crisis. We build a model to study
whether the interbank market can reviveif the reserve supply decreases suf-
ciently. The market may not revive due to balance sheet costs associated
with recent banking regulations. Although interbank volume may initially
increase as reserves decline from abundant levels, the balance sheet costs
may engender changes in market structure that completely replace interbank
trading by nonbank lending to banks. This nonmonotonic response could
lead to misleading forecasts about future interbank volumes.
JEL codes: E42, E58
Keywords: interbank market, monetary policy implementation, balance
sheet costs
O developments in U.S. money
markets since the 2007–2008 nancial crisis is the decrease in interbank trading vol-
ume. Before the nancial crisis, trading volume in the interbank market was estimated
to be about $100 billion per day. In 2018, it was less than $5 billion.
The reasons behind this decline are well understood. Before the crisis, the Fed
relied on scarce reserves and reserve requirements to implement monetary pol-
icy.1Payment shocks, which alter banks’ reserve holdings, along with scarce ex-
cess resources compelled banks to trade with each other over the course of a day to
The views expressedin this paper are those of the authors and do not necessarily reect those of the Fed-
eral Reserve Banks of Atlanta and New York,the Federal Reserve Board, or the Federal Reserve System.
We thank participants and discussants at multiple conferences, including 2017 FRBNY SOMA Portfolio
Seminar,2018 Federal Reserve Day-Ahead Conference, 2018 Fed-UMD Short-Term Funding Conference,
and 2019 ECB Workshop on Money Markets;and seminar participants at Banque de France, Dallas Fed,
FDIC, Federal Reserve Board, and Swiss National Bank.
KK is a Senior Economist at the Federal Reserve Board (E-mail: kyungmin.kim@frb.gov).
A M is a Senior Vice President at the Federal Reserve Bank of New York (E-mail:an-
toine.martin@ny.frb.org). E N is a Vice President and Senior Economist at the Federal Reserve
Bank of Atlanta (E-mail: ed.nosal@gmail.com).
Received October 18, 2018; and accepted in revised form November 13, 2019.
1. See Ennis and Keister (2008) for a theoretical exposition.
Journal of Money, Credit and Banking, Vol. 52, No. 7 (October 2020)
© 2020 The Ohio State University
1646 :MONEY,CREDIT AND BANKING
satisfy their reserve requirements. These trades generated high volumes. Following
the bankruptcy of Lehman Brothers, the Federal Reserve signicantly increased the
supply of reserves, rst through liquidity injections and then through large-scale asset
purchases, ultimately injecting almost $3 trillion of reserves into the banking system.
As a consequence, almost all banks held reserves at a level that far exceeded what
was required. This essentially eliminated the need for banks to trade with each other
to offset their payment shocks.
In this paper, we ask if U.S. interbank trading volumes can be revived. Contrary
to what is commonly believed, we nd that draining excess reserves to precrisis lev-
els will not necessarily generate high trading volumes. Although a small increase in
interbank trading volume will likely appear at the early stage of reserve draining, it
is not certain that market volumes will continue to grow with the further draining of
reserves. Indeed, we show that in some circumstances, interbank trading volumes can
disappear as reserves are drained further. These results imply that monetary and reg-
ulatory frameworks that rely on benchmark rates generated from interbank activity
may not be viable even if excess reserves shrink to precrisis levels.
A key insight that underlies these results is related to the stricter banking regula-
tions that impose signicantly higher balance sheet costs on banks in the postcrisis
period. Banks regulated in the United States consistently identify two new postcrisis
regulations—the Basel III leverage ratio and the Federal Deposit Insurance Corpo-
ration’s (FDIC) assessment fee—as key determinants of their balance sheet costs.
These regulations, in turn, have implications for banks’ borrowing and lending de-
cisions.2We think about these costs as being primarily related to the size of banks’
balance sheets.
The existence of balance sheet costs—both at the margin and in the aggregate—
has implications for the patterns of trade in money markets. To understand the link
between costs, the size of the balance sheets, and money market activities, consider
a simple example with one cash-rich nonbank and two banks. Suppose rst that the
nonbank renews a loan to bank 1 and bank 1 makes an interbank loan of the same
amount to bank 2. The size of bank 1’s balance sheet is unaffacted—the interbank
loan replaces the reserves lent on the asset side of its balance sheet—while the size
of bank 2’s balance sheet increases—both the asset and liability sides of the balance
sheet increase by the amount of the loan. Hence, the size of the balance sheet, as well
as balance sheet costs, of the banking system increases.
Consider now a different set of transactions that result in the same movement of
reserves from bank 1 to bank 2. Suppose now the nonbank does not renew the loan it
made to bank 1 and instead lends to bank 2. Everything else being equal, the reserve
holding and the balance sheet size of bank 1 will decrease and bank 2 will see its
2. TheFDIC assessment fee is in the order of several basis points. The rules for determining the fee are
published on the FDIC’s website, with actual numbers for various bank categories (https://www.fdic.gov/
deposit/insurance/assessments/proposed.html). The cost due to the leverage ratio is less straightforward to
quantify and would vary by banks. The FDIC assessment fee would be a reliable lower bound for the total
cost, but anecdotally market participants tend to quote substantially larger numbers than those implied by
the FDIC fee alone in discussing balance sheet costs. CGFS (2017) discusses balance sheet costs in detail.
KYUNGMIN KIM, ANTOINE MARTIN,AND ED NOSAL :1647
reserves and its balance sheet increase by the amount of the nonbank loan. Unlike
above, the size of the balance sheet of the banking system does not change. Hence,
banks may have an incentive to either reduce or avoid interbank trades if they can
both benet from an arrangement that moves reserves between them but does not
increase aggregate balance sheet costs.
We develop a model in the spirit of Poole (1968) that formalizes this example. As
in Poole, and consistent with actual market practice, we assume that nonbanks make
loans to banks early in the day, before banks receivepayment shocks. I nterbank trad-
ing can offset these shocks by redistributing reserves among banks. What is new is
the idea that nonbanks can also delay lending to the banks until later in the day, after
the payment shock is realized. For simplicity, we assume that the delayed lending
occurs at the same time as when the interbank market operates. If marginal balance
sheet costs are zero, then interbank trading is costless and banks can completely off-
set payment shocks by relying solely on the interbank market. In this situation, if
nonbanks face any costs associated with delaying their lending to banks, they will
have no incentive to do so. When marginal balance sheet costs are strictly positive,
interbank trades become costly and banks will not fully offset payment shocks in the
interbank market. Delayed loans from nonbanks can now help offset the shocks and
are more valuable to banks than early loans (made before the shocks). As a result
banks are willing to pay higher interest for late borrowing. A higher rate for delayed
loans can provide an incentive for nonbanks to make late loans even when there is a
cost associated with the delay.
Weshow that the nature of the delay costs that nonbanks may face has implications
for trade volume in the interbank market. If nonbanks face a cost per dollar of loan
delayed, then some interbank trading can reappear when reserves become scarce.
But the level of interbank trading will fall short of the precrisis levels in part due
to late nonbank loans displacing interbank loans. If, instead, there is a system-wide
xed cost associated with delaying loans because, for example, there is a one-time
cost associated with establishing market standards or an infrastructure that facilitates
late day trading, then as above interbank trading will reappear initially as reserves
are drained. However, if the supply of reserves continues to decrease, the system-
wide benet of nonbanks making delayed loans to banks will at some point exceed
the xed cost. If the xed cost is paid, then interbank trading volume will shrink to
zero since banks can obtain any needed reserves from nonbanks.
As far as we know, we are the rst to seriously evaluate the prospect of the revival
of the interbank market in the context of a model that can explain important features
of money markets before and after the 2008 nancial crisis. Our paper contributes to
a growing literature on money markets and monetary policy implementation. Recent
contributions include: Chen et al. (2016) who focus on monetary policy implemen-
tation in a model with preferred habitat features; Martin et al. (2013) who focus on
tools available to the Federal Reserves to implement monetary policy with a large
supply of reserves; Afonso and Lagos (2015) who develop a search model to under-
stand trade dynamics in the Federal Funds market; Armenter, and Lester (2017) who
use a model with directed search to study the Federal Reserve’s overnight reverse
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