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Banking

Examining the Effects of Paying Interest on Reserves

The Federal Reserve began paying interest on reserves (IOR) balances held in accounts in October 2008. Initially, different rates were paid on required reserves and excess reserves. However, the rate at present, 0.25 percent, is the same for required and excess balances.

pile of bills

After two years, it is interesting to look at the effects of paying interest on reserves and how it may have affected the funds market and banks' business models.

Outcomes of paying interest on reserves
An expected outcome from paying interest on excess reserves was that the rate paid on these reserves would set a so-called floor under the federal funds market—in other words, federal funds would not trade for less than the interest paid on excess reserves. If banks couldn't earn at least as much trading in the federal funds market as what they were earning on their reserves balances, their incentive to supply funds into that market would not exist.

Consequently, rates in the federal funds market would be expected to be greater than or equal to the rate paid on excess reserve balances. However, this potential outcome has not been the observed experience. Federal funds have continued to trade at rates below those paid on reserves balances. A potential explanation lies in the fact that institutions other than banks, principally insurance companies and government-sponsored entities, also have access to the federal funds market. These institutions do not maintain reserves with the Federal Reserve and thus do not have IOR as an alternative. Consequently, they continue to participate in the federal funds market and are willing to lend funds at a rate below that paid on excess reserves balances.

Does IOR restrict lending?
Some banking industry observers believe that IOR may have caused banks to hold excess reserves rather than use them to fund loans, noting that paying interest has narrowed the spread between the interest earned on a loan and the interest earned by simply holding funds in a Federal Reserve account.

Other observers have noted that extending a loan simply turns excess reserves into required reserves because of the deposit created when a loan is extended. (Balances held in transaction accounts are used to determine reserve requirements.) Because the rates paid on required and excess reserves are currently the same, IOR has no affect on the opportunity cost of extending a loan for the banking system as a whole. However, individual institutions may have differing preferences for excess and required reserves.

Still another point of view holds that current large reserves balances are not the result of IOR but instead are held as precautionary liquidity. But if these funds were not held in a Federal Reserve account, they would instead be invested in some short-term, low-risk asset, such as repurchase agreements or Treasury bills. What matters to a bank is the risk-adjusted rate of return on an investment or loan versus the best alternative use of the funds. Therefore, paying IOR affects the willingness of banks to make loans only to the extent that the risk-adjusted return on the alternative investment is less than the IOR.

Examining IOR's ongoing purposes
Several factors argue in favor of continuing to pay interest on excess reserves. For instance, as Federal Reserve chairman Ben Bernanke said in an August speech, if interest rates fell to zero, money markets could shut down, making it more difficult for the Federal Reserve to raise short-term interest rates in the future as there would not be a mechanism or market through which to do so. However, IOR can easily be set to zero and not have money markets shut down, as was the situation prior to the payment of IOR. In the current environment, the level of reserves in the system is so large that there is no scarcity and hence no market rate greater than IOR.

In addition, reserves balances are used to make interbank payments and, as such, serve as the final form of settlement for many transactions. In the past, the quantity of reserves needed for payment purposes has typically exceeded the quantity consistent with the Federal Reserve's targeted interest rate. As a result, the central bank has been faced with the task of managing the quantity of daylight reserves needed for transactions and then shrinking that demand by the end of the day consistent with maintaining target interest rates for overnight funding. Managing these goals is more effectively achieved when excess reserve balances are high.

Finally, the Federal Reserve provides daylight reserves by lending directly to banks. To the extent that this lending is not necessary, the Federal Reserve's credit risk exposure is reduced. In summary, an important justification for IOR is that it induces higher reserve balances, which reduces the need for daylight credit and thereby mitigates the central bank's need to extend the credit necessary to keep the payments system running efficiently. Mitigating those needs can mean mitigating the related risks. In short, IOR can help manage rates in an environment where a lot of reserve creation has occurred, as has been the case since 2008.

November 30, 2010