Regulatory Requirements of Banks and Arbitrage in the Post-Crisis Federal Funds Market

This paper explains the nature of interest rates in the U.S. federal funds market after the 2007-09 financial crisis. We build a model of the over-the-counter lending market that incorporates new aspects of financial markets: abundance of liquidity, different regulatory standards for banks, and arbitrage opportunities created by limited access to the facility granting interest on excess reserves. The model determines the equilibrium federal funds rate as a function of the policy rates and explains the "leaky floor" phenomenon: federal funds rates being strictly below the interest rate paid on reserves. Using the model, we explain the impact of raising government yields and tighter Liquidity Coverage Ratio (LCR) and the Supplementary Leverage Ratio (SLR) requirements on the federal funds rates