Reserve regulation and recourse as a source of risk premia in the federal funds market

In this paper we demonstrate that there is a pronounced and persistent daily pattern of returns in the federal funds market, centered on Wednesday. We present evidence that explains this phenomenon as a reflection of the optimal behavior of banks operating in an environment in which there are effective reserve requirements and a penalty cost for recourse to discount borrowing. In particular, we report empirical evidence that shows there was a significant upward shift in the amplitude of this pattern of daily returns that resulted from (1) the increase in uncertainty associated with the change in Federal Reserve operating procedures during the 1979-1982 period, and (2) the imposition of a surcharge on discount borrowing instituted by the Federal Reserve. Our results demonstrate that what otherwise might be regarded as anomalous interest-rate behavior is consistent with the optimal response of banks to the regulatory environment within which they operate.