I noticed that the interest rate on excess reserves and the fed funds rate are almost exactly the same at all times. Why is this the case? Shouldn't the credit risk of a bank be higher than the Federal reserve and shouldn't this premium be reflected in the Fed Funds rate?
Actually the IOER has slightly exceeded the Fed Funds rate in recent years. Currently IOER is 10bp and FF last set at 8bp for example. During the period 2009 to 2015, IOER was set at 25bp and FF averaged about 13bp. So what is going on? The FOMC sets IOER as a matter of policy , but FF is set by supply and demand for overnight loans between financial institutions in the Fed system. In this era of excess reserves , many financial institutions have excess cash, so the problem is to lend it at the best rate. The problem is that not all institutions can access IOER, because it is for depository banks only , so there is additional cash to invest held by others, such as the Federal agencies (home loan banks) for example. They invest in overnight Fed funds, driving the rate down below IOER. A bank could (and some do) borrow at these lower rates to invest in IOER, locking in a few bp.
Thus, the spread is driven by considerations of supply and demand rather than credit risk.
$\begingroup$ Ah I see that makes sense but I'm also curious about the credit risk element in isolation. If everyone had access to interest on excess reserves, is it true that the difference in FF and IOER would be different due to credit risk? Furthermore how different are their credit risks? Is there any rule that the overnight loan can't be spent on anything making the credit risk negligible? $\endgroup$ Jan 24, 2021 at 19:18
2$\begingroup$ There is zero credit risk on IOER because your counterparty is the Fed. So, if everyone had access to both IOER and FedFunds markets, then yes, Fed funds would trade at a higher rate due to the very small extra credit risk. How much? In a normal economic environment it might be a few bp. For reference , unsecured loans of one month usually trade at 10-15bp over Fed funds so it would be less than that. $\endgroup$– dm63Jan 25, 2021 at 2:29
$\begingroup$ I did a quick search for articles on this. My reading is that banks deal with credit risk mainly by limiting counterparty exposure rather than via price (spread). This leads to the dominance of the market segmentation story as described in this answer over credit risk. $\endgroup$ Feb 23, 2021 at 22:27
Both federal funds rate and rate on excess reserves are determined by Fed's Federal Open Market Committee (FOMC). These rates are not set by the market but by the decision of the Fed, which depends on their monetary policy. They are equal because FOMC set them to be equal.