March 07, 2007

Bernanke's Puzzle

The Fed may have trouble preventing cascading liquidity problems now that support for the dollar is so fragile. Such trouble could be close at hand given the unfolding subprime mess. Hamilton leads off by explaining how the Fed has averted past panics, but then goes on to explain how such power may not be available in the future.

Sources of Liquidity for Payments:

The Strategic Dimension

Banks must have enough liquidity to cover the amount of their

payments made over Fedwire.

1 i.e This liquidity typically consists of :

a) balances maintained on account with the central bank,

b) borrowing from other banks through the money markets,

c) credit extensions from the central bank, and

d) expected incoming transfers from other banks.

2 The last category creates a strategic challenge for banks in their liquidity management:

they each rely on one another’s payments as a source of funding.

The first source of funds available for making a payment is

the balances kept on account at Federal Reserve Banks. For

commercial banks, these balances consist of either required

reserve balances, excess reserve balances, or service-related

balances.

3 These balances and service-related balances for

August 2001 averaged $14.65 billion per day.

4 Banks are required to maintain these balances at a certain level during

two-week periods known as reserve maintenance periods. In

addition, the Federal Reserve can supply funds to the banking

market through open market operations. By purchasing

securities, the Federal Reserve directly increases banks’

balances held on account at System Banks.

Overnight balances at the Federal Reserve are costly to

maintain because they do not earn interest.

5 Nevertheless, if banks’ balances fall below the target on average for the twoweek

period, the banks face a penalty rate and must hold a

higher level of balances during the next two-week period. In

addition, if banks fall into overdraft positions on any given

night, they must pay a substantial penalty of 4 percentage

points in excess of the effective federal funds rate for that day.

As a result of these disincentives to falling short of required

balances and to holding excessive balances, banks try to target

their overnight balances within a narrow band.