Reserve Balances, the Federal Funds Market and Arbitrage in the New Regulatory Framework

Abstract

We study developments in reserve balances and the federal funds market in the context of two banking regulatory changes: the widening of the Federal Deposit Insurance Corporation (FDIC) assessment base and the introduction of the Basel III leverage ratio. Using a novel data set that includes FDIC fees and balance sheet data for depository institutions, we find that, as most foreign banks were not subject to the FDIC fee, they absorbed increasing amounts of reserve balances. Furthermore, foreign banks experienced positive and improving conditions for arbitraging between borrowing reserve balances in the federal funds market and earning interest on excess reserves by holding those reserves at the Federal Reserve Banks, contributing to an increase in federal funds borrowing by foreign banks relative to domestic banks. However, the implementation of the Basel III leverage ratio was associated with temporary declines in foreign bank federal funds borrowing at reporting dates.

Deviations from Covered Interest Rate Parity

“…Siriwardane (2016) shows that limited investment capital impacts pricing in the credit default swap (CDS) market. Our work is also closely related to recent papers on the interaction between the new U.S. monetary policy implementation framework and banking regulations, as discussed in Duffie and Krishnamurthy (2016), Klee, Senyuz, and Yoldas (2016), and Banegas and Tase (2016), and window dressing activities in repo markets on financial reporting dates (Munyan (2015)).…”

Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve

“…One way variations in the ONRRP and FHLB balances correlate with the demand for reserves is through the "window dressing" of European banks around month-ends. In Europe, the Basel III leverage ratio is calculated using only month-end data, which gives European banks an incentive to temporarily reduce their overnight borrowing around those dates, both in the federal funds market and from MMFs (Banegas and Tase (2020)). This window dressing has two effects on the market for reserves.…”

Arbitrage Capital of Global Banks

“…We focus on two types of arbitrage positions funded by unsecured borrowing. The first type is interest on excess reserves (IOER) arbitrage, in which banks obtain unsecured, shortterm dollar funding and hold the proceeds as reserves at the Federal Reserve, earning the spread between the IOER rate and their cost of short-term funding (Bech and Klee, 2011;Keating and Macchiavelli, 2017;Banegas and Tase, 2020). The second type is covered interest rate parity (CIP) arbitrage, in which banks borrow unsecured, short-term dollar funding from the cash market and then lend the dollars in the FX forward/swap markets (for example, Du, Tepper, and Verdelhan, 2018).…”