Banks Monitoring Banks: Evidence from the Overnight Federal Funds Market

This article describes a study which investigated whether banks could be employed as monitors of their peers by providing examination of the pricing of interbank lending agreements in the U.S. Although many ways to incorporate the marketplace into prudential supervision of banks can be imagined, one currently popular proposal envisages using banks themselves as monitors of other banks. This research investigates whether banks could effectively be employed as monitors of their peers by providing the first empirical examination of the pricing of interbank lending agreements. Banks lend significant amounts of money to one another every day in the federal funds market, the market where reserves are both bought and sold. These loans are both large and uncollateralized, and thus expose lending institutions to significant credit risk. Lending banks therefore have an incentive to monitor their counterparties and to price these loans as a function of, among other things, the credit risk of the borrowing bank. The main empirical finding of this article is that the interest rate charged on federal funds transactions reflects, in part, the credit risk of the borrowing institution.