The Federal Reserve Board published research finding that the bank-to-bank segment of the federal funds market provides real-time signals about liquidity distribution that aggregate reserve measures may obscure. Lending by Federal Home Loan Banks to foreign banks largely reflects arbitrage and reveals little about bank liquidity, while rates on transactions between banks respond to lenders’ reserve positions and emerging distributional frictions. Federal Home Loan Banks provide more than 90% of federal funds lending, and U.S. branches of foreign banks account for about 90% of borrowing, primarily through trades that capture the spread between federal funds rates and interest on reserve balances. Domestic banks instead use the market intermittently to meet liquidity needs. Smaller banks are more sensitive to deposit changes, while bankers’ banks provide an additional indicator because their reserve positions reflect conditions among the smaller institutions they serve. The findings suggest that granular transaction data, including the identity and reserve position of lenders, offer more information than the effective federal funds rate alone, which combines arbitrage and liquidity management activity. Bank lending rates become more responsive as aggregate reserves decline, indicating that the market’s diagnostic role could strengthen in a lower reserves environment.
U.S. Federal Reserve Board research identifies bank-to-bank federal funds trades as an early warning signal for liquidity stress
Federal Reserve Board research finds that bank-to-bank federal funds trades can reveal liquidity distribution pressures hidden by aggregate reserve measures. Trades involving Federal Home Loan Banks and foreign banks mostly reflect arbitrage, while domestic interbank rates respond to reserve positions and liquidity needs. These signals could become more informative as aggregate reserves decline.