What happened to US interbank lending in the financial crisis? Gara Afonso, Anna Kovner and Antoinette Schoar This column provides evidence that lending in the fed funds markets did not decline significantly immediately after the failure of Lehman Brothers as some practitioners and academics have suggested. Mean borrowing amounts remained stable in aggregate, although loan terms became more sensitive to borrower risk, and rates spiked. But at the same time, the market did not seem to expand to meet additional demand. Borrowing in the interbank market is the most immediate source of bank liquidity and, aggregate activity in the market can therefore be an important indicator of the functioning of the banking market. Problems in this market can lead to insufficient bank liquidity and thus to inadequate allocation of capital and risk sharing between banks. In addition, the (overnight) interbank rate, known as the fed funds rate in the US, is the main mechanism through which US monetary policy is channeled. It is therefore of particular interest to understand whether the interbank market mitigates or amplifies shocks to individual banks or the banking sector overall. Many recent economic theory papers predict a market freeze if lenders cannot assess bankspecific risks or fear liquidity shortages.1 We argue that observed conditions in the overnight fed funds market after Lehman Brothers’ bankruptcy do not support these theoretical concerns. The financial crisis period saw dramatic movements in the stock, bond and CDS prices of financial institutions. Many academics have documented the impact of the recent crisis on interbank funding, with mixed results: 

United Kingdom – Precautionary hoarding by settlement banks (Acharya and Merrouche 2009), fewer interbank lending relationships during the crisis (Wetherilt, Zimmerman and

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See Flannery, 1996; Heider, Hoerova and Holthausen, 2009; Acharya, Gale and Yorulmazer, 2009; Bruche and Suarez, 2010; Allen, Carletti and Gale, 2009; Diamond and Rajan, 2009, among others.

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Soramäki 2009), shifts in timing of interbank loans during the sub-prime turmoil (Halsall, Jackson and Merrouche 2008) 

Germany – Low risk of interbank contagion (Memmel and Stein 2008)

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Italy – Interbank rates become more sensitive to borrower characteristics (Angelini, Nobili and Picillo 2009)

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United States – “Run on repo” with increased haircuts in the $10 trillion repo market especially for lower quality assets (Gorton and Metrick 2009)

In recent research (Afonso, Kovner and Schoar, 2010), we examine the response of the US fed funds market to the bankruptcy of Lehman Brothers. In this column, we present our findings in an abridged form (see our article for more detail). Our conclusion is that while the market became more sensitive to borrower characteristics, it did not freeze. But at the same time, it also did not grow to meet the expected high demand as other sources of funding dried up. In particular, credit terms tightened for large banks in the two days after Lehman’s failure, especially those with worse performance. This implies that market participants changed their beliefs about whether large banks would be allowed to fail.

General stability in the aggregate fed funds market The overnight federal funds market was remarkably stable through the recent period of turmoil in the financial markets. Figure 1 shows daily amount of transactions and daily interest rate in the fed funds market, highlighting four key dates:2 i) August 9th, 2007 – BNP Paribas limits                                                              2

See Hellerstein, Ryan and Shrader, 2009 and http://www.newyorkfed.org/research/global_economy/Crisis_Timeline.pdf for a detailed description of the key events surrounding the financial turmoil after June 2007.

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withdrawals, ii) March 16th, 2008 – JP Morgan announces Bear Stearns acquisition, iii) September 15th, 2008 – Lehman Brothers files for bankruptcy, and iv) October 9th, 2008 – First effective day of interest on reserve balances.3 FIGURE 1: DAILY AMOUNT ($ BILLIONS) AND DAILY FED FUNDS RATE

Source: Authors’ estimates based on Federal Reserve Bank of New York data. 

The daily amount of transactions was surprisingly stable through the period, and began to fall only after the interest on reserves (IOR) period begins.

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The daily fed funds rate was relatively stable after the Bear Stearns’ episode until Lehman Brothers’ bankruptcy. The weighted average rate then jumped, with substantially more widening of the distribution.

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The Financial Services Regulatory Relief Act of 2006 authorizes the Federal Reserve to pay interest on reserve balances and on excess balances held by or on behalf of depository institutions beginning October 1, 2011. The effective date of this authority was advanced to October 1, 2008 by the Emergency Economic Stabilization Act of 2008.

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Tougher times for riskier banks The relative stability of amounts borrowed masks a dramatic shift in the flow of funds and the distribution of rates across different borrowers: larger borrowers accessed the interbank market less often after Lehman’s bankruptcy and experienced a sharp increase in spreads. These effects were particularly strong for large banks with high percentages of non-performing loans (NPL). In contrast, small banks did not experience the same fall in loan amounts. However, immediately before the Federal Reserve’s $85 billion loan to AIG was announced on September 16th (and again, weeks later, after the initial Capital Purchase Program (CPP) announcement on October 14th ) spreads for large banks returned to pre-crisis levels or below, although borrowing amounts remained lower. These results suggest that Lehman’s bankruptcy led to a change in beliefs about whether the authorities would let big banks fail. In response, we see that lenders started both pricing the credit risk of, and reducing exposure to, poorly performing large banks (rather than a complete freeze of the market).

Worse performing banks do not lend less We do not see the same patterns in lending as we do in borrowing. Lender characteristics such as NPLs are not associated with changes in the amount lent immediately after Lehman Brothers. This means that even riskier banks did not hoard funds on the Monday and Tuesday after Lehman’s failure. There is some evidence that especially larger banks lent to more counterparties (although they did not change aggregate lending amounts). It is impossible to know if these lenders were trying to send a positive signal to the interbank market or simply did not want to

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hoard cash. These results do not seem consistent with liquidity hoarding by banks in the interbank market in the financial crisis.

Banks not indiscriminately driven to the discount window, but unmet demand likely While we appear to document a functioning fed funds market immediately after the Lehman crisis, we only measure loans that were made, not all the loans that banks may have wanted. Presumably, demand for funds increased at the same time, so unmet demand may have been a problem. There was increased demand for discount window borrowing. However, banks that accessed the discount window were likely to be less profitable. Thus, while we cannot rule out that some banks were screened out of the market, the turmoil in the interbank market cannot have been so big that completely normal and solvent banks had to turn to the discount window for liquidity. This provides further evidence that the interbank market was not completely frozen through the crisis. However, it seems likely that unmet demand existed in the market. Banks that would be expected to demand more funds, such as banks with higher pre-crisis reliance on repo funding, did not increase borrowing in the fed funds market. Similarly, when using a multivariate specification to predict demand, predicted demand is much higher than actual borrowing immediately following Lehman’s bankruptcy, especially for low quality banks.

Conclusions

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In the immediate aftermath of Lehman’s bankruptcy, the fed funds market seemed to become sensitive to bank specific characteristics, in not only the amounts lent to borrowers but even in the cost of funds. We see sharp differences between large and small banks in their access to credit: Large banks show reduced amounts of daily borrowing after Lehman and borrow from fewer counterparties. Assuming that in the very short-run banks do not change their demand for liquidity, these results are consistent with credit rationing of large banks. In contrast to some theoretical models, we do not find evidence of a complete cessation of lending, nor do we find evidence that riskier lenders are more likely to hoard liquidity at the height of the crisis. Disclaimer: The views presented are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System.

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References Acharya, V., Douglas Gale and Tanju Yorulmazer (2009), “Rollover Risk and Market Freezes", New York University working paper, http://www.nyu.edu/econ/user/galed/papers/paper09-08-31.pdf Acharya, V. and Ouarda Merrouche (2009), “Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis”, NYU working paper, http://pages.stern.nyu.edu/~sternfin/ vacharya/public_html/acharya_merrouche.pdf Afonso, G., Anna Kovner, and Antoinette Schoar (2010), “Stressed, not Frozen: The Federal Funds Market in the Financial Crisis”, NBER Working Paper (15806). http://sites.google.com/ site/ garaafonso/ research. Allen, F., Elena Carletti and Douglas Gale (2009), “Interbank Market Liquidity and Central Bank Intervention”, Journal of Monetary Economics, 56(5), July 2009, 639-652. Angelini, P., Andrea Nobili and Maria Cristina Picillo (2009), “The interbank market after August 2007: what has changed and why?”, Bank of Italy working paper number 731, October 2009. Bruche, M. and Javier Suarez (2010), “Deposit Insurance and Money Market Freezes”, Journal of Monetary Economics, 57(1), 45-61. Diamond, D.W. and Raghuram G. Rajan (2009), “Fear of Fire Sales and the Credit Freeze”, University of Chicago Booth School working paper, http://faculty.chicagobooth.edu/douglas.diamond/research/Fear%20of%20Fire%20April%2019.pdf Flannery, M. (1996), “Financial Crises, Payment System Problems, and Discount Window Lending”, Journal of Money, Credit and Banking (November 1996, Part II), 804‐824. Gorton G. and Andrew Metrick (2009a), “Securitized Banking and the Run on Repo“, Yale ICF Working Paper number 09-14. Halsall, C., John Jackson and Ouarda Merrouche (2008), “Interest Rate Volatility and the Timing of Interbank Loans in the Sterling Money Market 2003-2008”, working paper. Heider F., Marie Hoerova and Cornelia Holthausen (2009), “Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk”, European Banking Center Discussion Paper No. 2009-11S, Center Discussion Paper Series No. 2009-40S Hellerstein, R., William Ryan and Jeffrey Shrader (2009), “The New York Fed’s timelines of policy responses to the global financial crisis”, VOX, http://www.voxeu.org/index.php?q=node/3764

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Memmel, C. and Ingrid Stein (2008), “Contagion in the German interbank market”, working paper http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2008-athens/Memmel.pdf Wetherilt, A., Peter Zimmerman and Kimmo Soramäki (2009), “The sterling unsecured loan market during 2006– 2008: insights from network topology”, Simulation analyses and stress testing of payment networks, Scientific monographs E: 42, 277-314.

 

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