5. What is the primary risk of trading in the fed funds markets? How did this risk come into play during the financial crisis of 2008–2009? Flashcards
What is the primary risk of trading in the fed funds markets?
One of the primary risks of the interbank lending system is that the borrowing bank does not have to pledge collateral for the funds it receives, which are usually in millions of dollars. The interbank loans are conducted with little scrutiny between parties.
How did this risk come into play during the financial crisis of 2008–2009?
The financial crisis of 2008‐2009 produced unprecedented and persistent strains in interbank lending and exposed problems produced by banks that were heavily leveraged with fed funds. The financial crisis created a huge demand for liquid assets across the entire financial system. Rather than lend excess funds in the interbank market, banks preferred to hold onto liquid assets just in case their own needs might increase. Banks also grew concerned about the risks of borrowing banks and became increasingly unwilling to lend (even at very high interest rates) as the level of confidence in the banking system dropped. Interbank loans fell to $153 billion in June 2010 from a peak of $494 billion in September 2008. Unable to borrow in the interbank market, U.S. banks turned to the Fed for short-term borrowing, and the Fed obliged.
