The Federal Reserve Bank of New York has released a Staff Report by Gara Afonso, Anna Kovner, and Antoinette Schoar titled Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis:
This paper examines the impact of the financial crisis of 2008, specifically the bankruptcy of Lehman Brothers, on the federal funds market. Rather than a complete collapse of lending in the presence of a market-wide shock, we see that banks became more restrictive in their choice of counterparties. Following the Lehman bankruptcy, we find that amounts and spreads became more sensitive to a borrowing bank’s characteristics. While the market did not contract dramatically, lending rates increased. Further, the market did not seem to expand to meet the increased demand predicted by the drop in other bank funding markets. We examine discount window borrowing as a proxy for unmet fed funds demand and find that the fed funds market is not indiscriminate. As expected, borrowers who access the discount window have a lower return on assets. On the lender side, we do not find that the characteristics of the lending bank significantly affect the amount of interbank loans it makes. In particular, we do not find that worse performing banks began hoarding liquidity and indiscriminately reducing their lending.
Normally, Fed Funds borrowers are allocated a line by their lender and rates are generic within that limit. After the Lehman bankruptcy, rate stratification was observed:
We use transaction level data of participants in the fed funds market to investigate the provision of credit in this market after the Lehman Brothers’ bankruptcy. We find a much more nuanced picture: Under “normal” or pre-crisis conditions the fed funds market functions via rationing of riskier borrowers rather than prices, e.g. adjustments of spreads.1 After Lehman we see a different picture emerge: In the days immediately after the Lehman Brothers’ bankruptcy the market seems to become sensitive to bank specific characteristics, not only in the amounts lent to borrowers but even in the cost of overnight funds. We see sharp differences between large and small banks in their access to credit: Large banks (especially those with high percentages of nonperforming loans) show drastically reduced daily borrowing amounts after Lehman and borrow from fewer counterparties. In fact, the interest rate spread at which large banks borrow in the fed funds market after Lehman falls below pre-crisis levels after September 16th, 2008. We interpret this initial response as an effect of credit rationing. In contrast, smaller banks were able to increase the amount borrowed from the interbank markets and even managed to add lending counterparties during the crisis; but to do so they faced higher interest rate spreads. Different from the predictions of many theoretical models of interbank lending, when faced with a market wide shock, we do not observe a complete cessation of lending but instead we see increased differentiation between borrowers of high versus low type.
Too-Big-to-Fail moral hazard had an immediate market effect:
After the AIG bailout is announced, spreads for the largest banks fall steeply, falling below the rate in the week before Lehman. We interpret the return to pre-crisis spreads as the effect of the government’s support for systematically important banks, because the same is not true for small banks: these banks continue to face higher spreads till well after the announcement of the CPP.
There was a high degree of differentiation shown by discount window usage:
Because of the high interest rate and potential for stigma, banks usually access the discount window only if they face severe unmet liquidity needs. Thus use of the discount window gives a lower bound for the unmet liquidity needs in the fed funds market. We find that even in the days after the Lehman Brothers’ bankruptcy only very poorly performing banks, those with low ROA, access the discount window. It seems reasonable to assume that these are banks which were rationed by private banks lending in the fed funds market. While again it is difficult to assess whether this means that interbank markets operated efficiently after the crisis, it is, however, reassuring that we do not observe that well performing banks are forced to turn to the discount window. This would have been a very alarming indication of dysfunction in the fed funds market.