Editor's note: This post was coauthored with Don Kohn
At Janet Yellen’s recent hearing before the House Financial Services Committee, a few representatives expressed concern that the Federal Reserve is making interest payments to banks. Specifically, the Fed uses authority granted by Congress in 2008 to pay interest on the reserves that banks hold with it. Total payments to banks last year were about $7 billion. Why is the Fed paying such sums to banks? Are they “giveaways” to the financial sector, as some have implied? We’ll argue in this post that the interest payments the Fed is making are well-justified. In particular, they are essential to prudent monetary policy in current circumstances and do not unduly subsidize banks.
Why is the Fed paying interest on bank reserves?
Reserves are deposits banks have at the Federal Reserve; some are required by law to be held against checking deposits, but banks also hold reserves at the Fed in excess of requirements. Importantly, the amount of Fed deposits held by the banking system as a whole is determined by Federal Reserve open market operations, not by the banks themselves.
Before the Fed paid interest on reserves, banks engaged in wasteful and inefficient efforts to avoid holding non-interest-bearing reserves instead of interest-bearing assets, such as loans. For example, many banks set up mechanisms for moving funds at the end of the business day from accounts which bore higher reserve requirements to accounts which had lower or no reserve requirements. By paying interest on reserves, the Fed made such efforts unnecessary.
More importantly, in recent years the Fed’s ability to pay interest on reserves has become essential to the smooth implementation of monetary policy. The Fed influences the economy by raising and lowering its target for the federal funds rate, the interest rate at which banks lend reserves to each other overnight. Changes in the federal funds rate in turn influence other interest rates and asset prices. In the past, the Fed achieved the desired level of the federal funds rate through market operations that affected the amount of bank reserves in the system. By making bank reserves more scarce, the Fed pushed up the price of reserves—the federal funds rate. By making reserves more plentiful, it pushed down the funds rate.
However, as a consequence of the large-scale asset purchases that the Fed undertook between 2008 and 2014 to help support the US recovery—purchases that were financed by the creation of bank reserves—the quantity of reserves in the system is now very large. Because banks are essentially satiated with reserves, modest changes in the supply of reserves will no longer have much influence on the federal funds rate. Rather than varying the supply of reserves, the Fed now manages the federal funds rate by changing the rate of interest it pays on reserves (as well as the interest rate it offers in so-called reverse repo transactions with money market funds and other private-sector institutions). These changes influence the federal funds rate and other short-term funding rates, and thus financial conditions more generally. As part of its decision to increase rates in December, the Fed increased the interest rate paid on reserves from one-quarter to one-half percent; short-term interest rates in financial markets rose in parallel as expected.
This basic approach, moving the interest rate paid on bank reserves to influence short-term market rates, is used by the European Central Bank, the Bank of England, the Bank of Japan, and many other central banks. In current circumstances, without the ability to pay interest to banks and other private counterparties, the Fed would likely have to implement any tightening of monetary policy by rapidly selling assets it holds. This would have difficult-to-predict effects and would likely prove highly disruptive to financial markets, to say the least.
Where does the money come from to pay the interest on reserves?
To answer this question, keep in mind both sides of the Fed’s balance sheet. The reserves in the banking system (which are liabilities of the Fed) were created when the Fed made large-scale purchases of interest-bearing securities (the corresponding Fed assets). The interest received by the Fed has thus far been much greater than the interest it has paid out. The difference between interest received by the Fed and the interest paid to banks—over $550 billion since 2009—is turned over to the US Treasury.
Does paying interest on reserves prevent banks from lending?
This claim, made even by some good economists, is puzzling. Before December, the Fed paid banks one-quarter of one percent on their reserves. If the Fed had not paid interest, the return to reserves would have been zero. Accordingly, the only potential loans that would have been affected by the Fed’s payment of interest are those with risk-adjusted short-term returns between precisely zero and one-quarter percent—surely a tiny fraction of the total. In fact, over the last four years bank lending has increased at about a 5 percent annual pace(including around a 7 percent annual rate the past two years), with only residential mortgage lending lagging in the aftermath of the housing bust.
Does paying interest on reserves subsidize banks?
Reserves are an asset on banks’ balance sheets, and, like any bank asset, they must be funded by corresponding liabilities. The federal funds rate, which is what banks pay to borrow from other banks, is one reasonable measure of the marginal cost of funds to banks. Since the Fed’s action to raise rates in December, the funds rate has generally fluctuated around 37 basis points (a basis point is .01 percentage points). Consequently, we can safely say that the subsidy to banks implicit in the Fed’s interest payments can be no greater than the difference between the 50 basis points (one-half percentage point) the Fed now pays on reserves and the 37 basis points or so that banks must pay to finance their reserve holdings—that is, about 13 basis points (13/100 of one percent).
From an economic point of view, however, even 13 basis points is probably an overstatement of any subsidy. Here’s why: If the full marginal cost to banks of adding reserves was simply the funding cost, then a bank could borrow in the market at the fed funds rate, deposit that money at the Fed, and earn the higher rate of interest on reserves while taking no risk. In principle, this activity should lead the market-determined federal funds rate to be very close to the interest rate paid on reserves—indeed, that’s what many at the Fed expected to happen when Congress authorized payments of interest. The fact that there is a persistent differential between banks’ funding costs and the interest rate they receive on reserves suggests that there may be additional costs to banks of holding reserves, above the explicit marginal cost of funding.
It is not difficult to identify such costs. For example, banks are required to hold capital against even very safe assets, including reserves at the Fed, because of the so-called leverage ratio. Because equity capital is relatively more expensive for banks, these requirements increase the effective marginal cost of funding reserves. Similarly, the premiums charged banks by the Federal Deposit Insurance Corporation for insuring deposits are tied to the level of bank assets, including reserves; the extra premiums are another cost of increased reserve holdings. In short, the absence of bank efforts to obtain additional reserves at current interest rates suggests that much of the difference between the interest rate banks receive on reserves and their explicit marginal cost of funds is eaten up by other costs tied to holding reserves.
Doesn’t the Fed’s writing checks to bank create a perception problem?
Yes, unfortunately. Although the payment of interest on reserves provides no meaningful subsidy, the Fed does face an appearance problem from the fact that it is writing checks to banks. This problem will likely get worse if the Fed raises short-term interest rates further, because that would require raising the interest rate it pays on bank reserves as well. Of course, misplaced criticism is no reason not to do the right thing with monetary policy. But the Fed will need to make good economic arguments to explain why paying interest to banks is necessary.
A couple of factors may reduce the appearance problem over time. First, the Fed has already announced that, at some point, it will stop reinvesting the proceeds from maturing securities, thereby allowing its balance sheet to shrink to something approximating its pre-crisis size. As the balance sheet shrinks, so will the quantity of outstanding bank reserves. The Fed could therefore emphasize that it expects that the need to make substantial interest payments to banks is temporary, and that those payments will shrink as the balance sheet normalizes and the Fed returns to its more traditional approaches to managing interest rates. Moreover, at that point, the interest rate on reserves is likely to be at or below market interest rates and thus at best a wash for banks.
Second, the Fed is currently targeting a 25-basis-point range for the federal funds rate, with the interest rate on reserves at the top end of that range. With experience, the Fed should be able to shrink its target range, with the effect that the federal funds rate will draw even closer to the interest rate paid on reserves. It should then be easier to explain why banks are not receiving a subsidy from the Fed, as it will be evident that they are earning about the same on their reserves as they could receive in the open market. Of course, while its communications challenges are real, the Fed’s first priority must always be to put in place the right monetary policy for our economy.