Tuesday, December 2, 2008

Attention Bankers: Bernanke Is Providing You A Profitable Arbitrage On A Silver Platter

During yesterday's speech, Fed chairman Bernanke pointed out an odd occurrence in the Fed Funds market. Despite the fact that the Fed is paying interest on reserves at the target rate of 1%, Fed Funds are trading below 1% (As of yesterday, the effective Fed Funds rate was .52%). Why would banks seemingly loan out money below 1%, when they can get 1% from the Fed. Well they are not. Here is what is going on :
Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited. Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.
As of yesterday, the effective Fed Funds rate was .52%, which provided Bernanke the opportunity in a footnote to his speech to point to a riskless arbitrage for bankers:

Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

2 comments:

  1. Can I ask a dumb question? Why does Fannie or Freddie have reserves with the Fed? Is this a new thing? Can GM trade in the fed funds market too?

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  2. Bob,

    GSEs (which includes Frannie and Fredde), some international institutions have had accounts with the Fed and also the Treasury (which is parking all those huge reserves at the Fed).

    None of these entities are being paid interest by the Fed on their deposits.

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