Financial Update (July-September 1999)
DID YOU KNOW?
Sweep Accounts Lower Reserve Balances, Complicate Fed Funds Targeting
oth regulatory changes and technological innovations have brought dramatic changes to the banking industry during the past two decades. But one of banks' primary businesses is still handling and safeguarding individuals' and businesses' money. And banks are still in business to make a profit.
In many ways, banks must walk a straight and narrow path between regulatory restrictions on the one hand and the innovations that technology makes possible on the other. Within that path, banks have become very creative in the methods they use to maximize the return on the funds in their keeping.
One innovation that has become increasingly popular with banks in the past five years is the use of "sweeps" — the practice of shifting funds out of customer accounts that are subject to legal reserve requirements and into accounts that are not subject to such requirements. Banks and customers are benefiting from this practice, but it has complicated the Federal Reserve's task of implementing monetary policy.
All U.S. depository institutions are legally required to hold reserves based on a percentage of their transaction deposits. Bank reserves consist of cash in banks' vaults and balances in the banks' accounts at Federal Reserve Banks. Many banks use their Reserve Bank accounts not only to satisfy their reserve requirements but also to clear financial transactions through the Fed; these institutions try to maintain a cushion of funds in their accounts to guard against unexpectedly large debits that could leave the accounts overdrawn and subject to penalty. This cushion is called excess reserves.
Since the Federal Reserve can't, by law, pay interest on reserves, banks essentially pay a cost for all the reserves they hold — the interest they could have earned by lending or investing those funds. So banks have come up with new ways to limit their amount of reserves.
One way banks can limit the amount of reserves they are required to hold is by "sweeping" funds out of accounts subject to reserve requirements into accounts that are exempt from reserve requirements. In the most common sweep arrangement, a bank temporarily, usually overnight, transfers funds from a checking account into a money market account and then returns the funds to the checking account the next business day; however, regulations limit the number of such automatic transfers to six per month per account. Since reserve requirements are calculated on a two-week daily average basis, even these temporary reductions in reservable deposits reduce the amount banks are required to hold as reserves.
Sweep accounts benefit banks by reducing required reserve balances, freeing up funds that can then be used to earn interest. Sweeps have been in widespread use for business accounts since the mid-1970s. But the advent of more sophisticated computer technology in the 1990s has enabled banks to sweep retail (household) checking accounts. Since 1995, the use of sweeps of retail accounts has escalated rapidly.
As the level of funds in sweep accounts has risen over the past few years, required reserve balances have shrunk. This decline has important implications for the market in which these balances are borrowed and lent — the federal funds market.
Falling Balances Affect Federal Funds Rate
Banks can control the level of funds in their reserve accounts by trading in the federal funds market. Banks with surplus balances in their reserve accounts can lend funds to banks that need to boost their balances to avoid being overdrawn. The interest rate charged on these transactions is the federal funds rate. (See "Federal Funds Market Plays Important Role in Monetary Policy," Financial Update, April-June 1999, 8-9.)
Banks' demands for reserves in the federal funds market depend on their level of daily payments. As sweep accounts have lowered the amount banks hold in their reserve accounts, banks have a smaller cushion of funds to cover unexpectedly large debits that can leave their reserve accounts overdrawn or below required maintenance levels at the end of the day. This reduction in required reserve balances has thus increased the likelihood that payments activity on any given day will push banks to borrow or lend in the federal funds market.
If a high level of payments activity on a given day leaves an unexpectedly large number of banks in need of funds to boost their reserve balances, the increased demand for funds can push up the federal funds rate. Even when the number of banks in need of loans is not especially large, payments activity that is otherwise heavy can make it difficult to easily match banks with excess funds with those in need of funds. Such demands in the market can lead to greater volatility in the federal funds rate and thus make the Fed's job of achieving a federal funds rate target on a day-to-day basis more difficult.
In carrying out monetary policy, the Federal Open Market Committee (FOMC) sets a target level for the federal funds rate. To influence the rate, the Federal Reserve's trading desk at the New York Fed decreases or increases the amount of reserves available in the federal funds market by buying or selling U.S. Treasury securities in the open market. As the increase in sweep accounts has lowered required reserve balances, it has become more difficult for the Federal Reserve to precisely hit its target rate.
How the Fed Is Managing Reserves
While intraday volatility in the federal funds rate has trended upward since 1995, the rise has been rather modest. So far, the higher volatility in the federal funds rate has not led to increased volatility in other short-term interest rates. Nor has it seemed to confuse market participants about the Fed's intended monetary policy stance.
But the possibility that the federal funds rate might vary more as the use of sweep accounts continues to grow and the desire to simplify reserve management for banks has led the Federal Reserve to look at ways to curb intraday volatility.
In July 1998 the Federal Reserve returned to a long-abandoned method called lagged reserve accounting for calculating banks' required reserves. This method sets the period for computing a bank's required reserves two weeks plus two days before the two-week period during which this balance must be maintained. This lag in computation and maintenance periods makes it easier for banks to estimate and project required reserve balances and more accurately manage their reserve positions. This method also makes it easier for the Fed to estimate the demand for reserves and thus should help reduce the volatility in the federal funds rate.
What Does the Future Hold?
Although the spread of sweep accounts has slowed during the past year, there are some concerns that the increased volatility in the federal funds rate might become significant if required reserve balances continue to fall. A few longer-term solutions have been proposed to alleviate this volatility.
One of these options would be for the Fed to eliminate reserve requirements, pay interest on any excess settlement balances and charge a penalty on deficient balances. This system would remove incentives to evade reserve requirements and could make the demand for reserves more predictable. The Bank of Canada operates under such a system.
Another option the Federal Reserve has proposed is to continue to require reserves but to pay banks interest on reserve balances. This option also would remove banks' incentives to evade reserve requirements and thus might stabilize the demand for reserves. Paying interest on reserves would have to be approved by Congress; however, that proposal is part of legislation currently being considered by the House.