Liquidity Risk, Bank Networks, and the Value of Joining the Federal Reserve System

The Federal Reserve System was created to reduce risks related to seasonal swings in loan demand and to stabilize fluctuations in interest rates. Many state-chartered banks chose not to join the system because of the cost of the Federal Reserve’s reserve requirements. The inability to attract many state-chartered banks created indirect access to government protection (lender of last resort) without federal regulation. (Working Paper no. 15-05)

Abstract

Reducing systemic liquidity risk related to seasonal swings in loan demand was one reason for the founding of the Federal Reserve System. Existing evidence on the post-Federal Reserve increase in the seasonal volatility of aggregate lending and the decrease in seasonal interest rate swings suggests that it succeeded in that mission. Nevertheless, less than 8 percent of statechartered banks joined the Federal Reserve in its first decade. Some have speculated that nonmembers could avoid higher costs of Federal Reserve requirements for reserves while still obtaining access indirectly to the Federal Reserve discount window through contacts with Federal Reserve members. We find that individual bank attributes related to the extent of banks’ ability to mitigate seasonal loan demand variation predict banks’ decisions to join the Federal Reserve. Consistent with the notion that banks could obtain indirect access to the discount window through interbank transfers, we find that a bank’s position within the interbank network (as a user or provider of liquidity) predicts the timing of its entry into the Federal Reserve system and the effect of Federal Reserve membership on its lending behavior. We also find that indirect access to the Federal Reserve was not as good as direct access. Federal Reserve member banks saw a greater increase in lending than nonmember banks.