Banks as monitors of other banks: Evidence from the overnight federal funds market

This study provides evidence that banks are effective monitors of their peers by showing that the interest rate paid on federal funds transactions reflects differences in credit risk across borrowers. In addition, the size and relative importance in the funds market of the trading institutions are shown to affect the rates charged for overnight borrowing, thereby providing insight into the nature of competition in the federal funds market. Transaction volume and size-of-transaction effects are uncovered, as is evidence of relationship banking between banks. These results are made possible by unique data identifying individual federal funds transactions.