Credit crunch in the U.S. interbank money market 2007-2008: issues in bank funding markets and federal reserve responses.

Abstract

This study discusses the interbank money market credit crunch in the United States in 2007-2008. The objective is to answer to the question of whether or not the actions of the Federal Reserve were effective and accurate in solving the crisis in the U.S. interbank money market based on the evaluations made in the academic community.

The study presents some theory on the liquidity and credit crunches and then moves on to explaining the issues in the interbank money markets and motives of the market operators during the time period examined. Finally the Federal Reserve responses to the problems in the interbank money markets are summarized and their effectiveness and accuracy is analyzed.

The methodology used in this study is a literature review with a graphical analysis and simple calculations regarding certain money markets based on data retrieved from varied sources of the Federal Reserve and other institutions. The review limits itself to the interbank money market funding in the United States and to the time period between June 2007 and June 2008. The instruments analyzed have a maturity of three months and lower.

The main result was that according to the evaluations, the Federal Reserve responses were in some cases effective although they were not strong enough to prevent the credit crunch from continuing. Cuts of the main policy interest rate were considered inflationary and ineffective to address the issues in the interbank money market. The arguments concerning the bailout of Bear Stearns, repo operations and central bank swap lines were mainly positive. The econometrical analysis is not extensive yet but the research made thus far suggest that the effects of new lending facilities (Term Auction Facility, Term Securities Lending Facility and Primary Dealer Credit Facility) have controversial results on the LIBOR-OIS spread but reduced spreads in the repo market. The main concern regarding the institution bailouts and accepting low-grade collateral was the increasing the risk of moral hazard, thus the irresponsible decision-making.