Why Federal Funds Rates Can Fall Below Interest on Reserves

Summary

The document explains an apparent rate arbitrage: the effective federal funds rate can be below the interest paid on reserve balances at the Federal Reserve. The answer attributes the gap to differences in which institutions can earn interest on reserves and the costs they face when taking part in the trade.

Federal Home Loan Banks, which are not eligible to receive interest on reserve balances, may lend funds in the federal funds market below that rate. Eligible U.S. branches of foreign banks can borrow those funds and hold them at the Fed, earning the spread. U.S. banks may have less incentive to do so because balance-sheet growth can raise their FDIC fees, making the trade unattractive despite its apparent positive spread. The explanation describes the institutional mechanism, but gives no measurements of trade size, net returns, or how the arrangement changes over time. Its account reflects the rules and rates described in the source and should not be assumed to apply unchanged under different policy conditions.

Key ideas

• Some lenders in the federal funds market are ineligible to earn interest on reserve balances.
• Eligible foreign bank branches can borrow funds and hold them at the Fed to capture a rate spread.
• FDIC fees tied to bank balance sheets can discourage U.S. banks from pursuing the trade.
• The apparent spread must be considered alongside eligibility and balance-sheet costs.

Tags

# Seeming arbitrage in excess reserves


# Seeming arbitrage in excess reserves












In the US banks are required to store 10% of their deposits in cash in the form of Fed Funds. Due to misbalance of demand and supply, some banks borrow such cash from others; the volume averaged overnight rate of borrowing is called effective fed funds rate, currently 0.15. At the same time, whatever banks store in fed funds gets interest on excessive (and required) reserves, which is 0.25. Why some banks choose to lend money to other banks at a lower rate, instead of putting this cash at fed at a higher rate?

## Answer by mdb6 (score 6)

https://quant.stackexchange.com/a/20873

Federal Home Loan Banks also hold reserves, but are not eligible to earn IOER, so they lend the cash into the fed funds market at a rate below IOER. U.S. branches of foreign banks, who are eligible to earn IOER, borrow from the FHLBs and deposit the proceeds in their accounts at the Fed, earning the spread. U.S. banks don't participate in this arbitrage because they take in retail deposits and are thus subject to an FDIC fee based on the size of their balance sheets, so they are disincentivized to participate in what is a high-volume, low-return trade.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.