Two Paradoxes: Interbank Lending, Commercial Paper

The talk is that the interbank lending market has frozen. Rates for overnight borrowing are around 5.4%, much higher than the Federal Reserve's discount rate, which is at 1.75%. Paradox: why would anyone borrow in the private market rather than from the Fed?

Second paradox is commercial paper, another market that is supposedly freezing up. Volume is down signficantly, true, you can see that in Federal Reserve data. But rates are not very high, say 3% for 3 month paper. Those data seem more consistent with a drop in supply of commercial paper rather than a drop in demand to hold. If demand to hold paper were low, then volume would go down but rates would go up.

There is a theory to reconcile these paradoxes, I think. And it reinforces the general idea that incomplete and asymmetric information is driving a lot of the patterns in all the markets.

Let me use loosely, as we sometimes do in our models, the idea of "good" banks and "bad" banks.

In the interbank market, the good banks -- those who know they are solvent -- will borrow from the Fed. The bad banks don't want to undergo the examination that I believe they will get from the Fed if they show up at the discount window. So they go to the interbank market and get charged an appropriate risk adjusted rate. And there is not much lending going on in that market, with credit being rationed on the basis of knowing that a counterparty is of decent risk.

A similar idea explains the commercial paper market -- essentially a credit rationing story. Only the best credit risks can sell their commercial paper. And they get a reasonable rate charged -- around 3%. The worse risks just cannot sell any paper at all. So the rate we see in this market is low, but that is because we are seeing only the best risks using the market.

So the Fed is stepping in to both markets, trying to get reserves to even the bad banks, and letting the marginal borrowers still access the commercial paper market.