In October of 2006, President Bush signed the Financial Services Regulatory Act (FSRA)...the culmination of a five year Congressional effort. Significantly, the Federal Reserve was given authority to pay interest on reserve balances held by depository institutions in Federal Reserve Banks. But not just reserve balances, which were required to be held, but also on excess reserves. Interestingly, excess reserves at the Fed had never been held in significant quantities. Banks saw relatively little reason to put working capital (beyond required levels) at the Fed. Excess reserves (as a % of required reserves) had generally vacillated between 5% to 15% and typically under $2 billion dollars, at any given time.
However, all this changed upon the implementation of FSRA (which was implemented ahead of schedule in conjunction with Secretary Paulson's Emergency Economic Stabilization Act of 2008 or EESA). The EESA was formally proposed Sept 21 of '08 and passed into law by Oct 3. The impact was a shocking increase in excess reserves. The FSRA law supposed intention was, according to the Fed's Oct. 6, 2008 press release...
"The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability."
The implication I took from this very convoluted Fed speak was that absent the Interest on Excess Reserves or IOER...that the Fed was concerned that the banks (by banks I mean Primary Dealer banks that directly buy the Treasury's from the government with the intention of reselling the Treasury's into the market) would actually utilize this money?!? The Fed's intent seems to have been to utilize QE to buy (remove) assets from the banks and then pay the banks not to lend this money, keeping it from entering the economy (chart below). Still, why would banks go along for this mere pittance of a 0.25% (significantly less than the banks were earning) when the funds could earn so much more if allocated? When the largest, most influential / connected banks in the land do something that looks dumb with $2.4 trillion dollars, it's pretty clear something has changed and we (I) simply haven't caught up yet. Was this some fashion of quid pro quo, collusion, or have the rules of capitalism changed?
By September '08 (in expectation of the laws passage), excess reserves had already increased from a couple billion $'s to never seen before level of $59 billion...and up to $800 billion by years end 2008. Of course, today $2.4 trillion in banking excess reserves are paid to sit and do nothing...while the Fed bemoans a lack of inflation?!?
Some Background:
In the US, bank reserves are held as FRB (Federal Reserve Bank) credit in FRB accounts, regardless whether the reserves are required or excess reserves beyond the Federal Reserve requirement. The definition of reserves (and by extension excess reserves) are monies not lent out to customers to satisfy Federal Reserve set requirements. One would think holding $2.4 trillion in excess reserves at 0.25% interest during one of the greatest bull market periods in history would be an opportunity cost as higher risk-adjusted interest could have been earned by putting these funds to use elsewhere. Strange banks were seemingly disinterested in the misallocation of their funds? Are there new or different requirements placed on the banks regarding reserves?
When the FSRA was passed in 2006, required reserves held at the Fed averaged about $8 billion and excess reserves under $2 billion. As of August '08...little had changed and required and excess reserves still stood nearly as they had in 2006.
- Notably, required reserves held at the Fed had been declining from the high water mark of $37 billion in 1988 against then liabilities of about $3 trillion...a 12.5% ratio. Obviously the leverage in '06 of $8 billion required reserves held against '06 liabilities of $8.5 trillion (less than 1% ratio) may have been a bit aggressive? By Aug of '08, required reserves of $8 billion were held against liabilities of $10.9 trillion (a 0.7% ratio).
Against the Fed mandated declining required reserves, mortgage debt and total liabilities of all commercial banks had grown nearly 6-fold (below).
However, from September '08, the quantity of required reserves began steadily rising (below).
But excess reserves held at the Federal Reserve went ballistic. The previously unutilized avenue of excess reserves at the Federal Reserve continuously rose, housing nearly 60% of all new banking liabilities from '08 onward.
Only 20% of the new liabilities were commercially lent and mortgage debt outstanding contracted, still to this day.
Was the FSRA and Fed's intent to create this massive holding of excess reserves? The primary discussion prior to the law was around the required reserves and the payment of interest upon these. And yet, now eight years subsequent to the laws implementation, required reserves are a tiny fraction of excess reserves. As the chart below highlights, from 2000-->Aug, 2008 (pre-FSRA implementation) essentially none of the new deposits (net) had been placed with the Federal Reserve. However, with immediate effect post FSRA, 57% of all new deposits from '08 through March, 2016 have (net) been held as excess reserves with the Fed.
Also interesting is that absent the utilization of this $2.4 trillion dollars (required and excess reserves combined), equities, RE, and most other asset classes (except the basis of all assets, commodities) have seemingly been unaffected and in fact have steadily risen 200% to 500% despite being starved of the new capital?!?
In order to see this phenomenon in it's fullness, the chart below highlights Fed Fund Rate % (FFR) vs. Excess Reserves. The moment the FFR hit zero interest rate policy (ZIRP) in conjunction with implementation of IOER...this cheapening of credit theoretically should have been met with record new credit issuance but instead at ZIRP, credit began strongly contracting. Banks stuffed the vast majority of new funds into a the Fed yielding 0.25% annually rather than lend?!?
The charts below are close ups of what happened with excess depository reserves during the past three recessions.
The chart below of the '91 recession shows the flash of reserves from just under a billion to $2.1 billion and the return of reserves to normal as interest rates were used to further heighten demand subsequent to the recessions conclusion.
Likewise, the chart below highlights the relationship in the '01 recession and safekeeping of assets associated with 9/11...
The chart below is the '08-'09 recession (vertical blue box with arrows top/bottom) and as rates hit zero, excess reserves ballooned from $2 billion to $1,200 billion. And this is where during all previous recessions the Fed continued to push rates down and excess reserves went back to work. But not this time. Excess reserves continued to pile up "post recession" as rates did not decline as they had coming out of previous recessions...ZIRP did not turn into NIRP (negative interest rate policy). The world was not ready for NIRP in '11.
Further, a massive implication of this quantity of reserves sitting at the Fed is the inability to effect interest rate policy as the Fed has since it's inception...via it's open market operations injecting or removing assets from bank reserves to impact overnight lending rates. In order to effect rates as the Fed has done historically, the Fed would need to drain the excess $2.4 trillion in excess liquidity to effect an increasing tightness in overnight rates. Clearly, the impact of draining this excess liquidity would likely be the equivalent of removing liquidity equal to 15% of US GDP. The impact on equities, RE, bonds, etc. would not be pleasant.
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So, lucky for us, the Fed in it's "wisdom" determined a means to raise rates without removing the excess reserves...or essentially rate hikes and QE simultaneously?!? Pay the banks a higher interest rate to incent them not to lend the excess reserves!?! The initial interest rate paid in '08 of 0.25% on a total of $10 billion was a relative rounding error. Chump change by Federal .Gov standards. But as the moonshot of excess reserves headed toward infinity, a 0.25% turned into real money or about $6 billion paid to banks in 2015 not to lend. But now with the Fed's rate hike cycle(?) underway, the Fed intends to continue hiking the interest paid corresponding to the Federal Funds Rate. This means in 2016 (at the present 0.5% rate) banks will be owed $12.5 billion to not lend money!?! Of course, if the rate cycle continues to say, 1% this year and 3% by 2018, and reserves don't decline substantially, banks will be paid about $75 billion annually by 2018 not to lend money (chart below).
As a final thought, a quick review of QE (charts below) shows that declining rates (based on 10yr treasury yields) were actually pushed upward during each QE period...and only once the completion date was announced did rates begin falling again. Ultimately, rates were reduced by 100% from 5% to 0% but no net demand was spurred and instead outstanding mortgage debt has fallen by nearly $1 trillion. Liabilities have increased by almost $3 trillion of which $2.4 trillion (80%) are excess reserves held with the Fed.
And a close-up of the Fed's QE and it's impact on the 10yr rate. Likewise to the IOER's, the Treasury market yields are falling to century low rates on the absence of nearly all buyers since the abandonment of the BRICS (net) as of 2011 and all foreigners (net) plus the Fed since the completion of the Fed's taper. These sources plus the fast waning intra-governmental buying via the SS surplus, had purchased 80%+ of all Treasury's since '00. Now, in these sources absence of making any net new purchases, we are to believe the US public (pensions, insurers, institutions, and individuals) are buying around $50 billion of record low yielding treasury's...and again this has no negative impact on equity markets, RE, etc. etc. and instead all are near record valuations?!?
In a world in which growth is slowing, is it not strange that the Fed (privately owned by the largest banks in the world) would institute a system of rising payments rewarding banks for not taking risk or lending money! This all tends to make believe that manipulation is the order of the day and the explanation is far simpler than most would believe, detailed Here.
And just in case you were wondering what the relationship of excess reserves, the Fed's balance sheet, and equity valuations looks like...here ya go.
