U.S. Would Profit Paying Interest On Reserves at Fed, ABA Says

Bankers Association on Thursday released a study showing that interest paid on required reserves would increase government revenues by $500 million over the next five years. "In the past, the belief that the impact on the budget would be negative has prevented action," ABA economist Michael ter Maat said. "It is time for this issue to be revisited based on what we now know the budget impact will be." In an estimate sent to Congress in March, the group said it would take nine years before Treasury profited from the move. That estimate, however, did not account for the taxes banks would pay on their interest earnings. Also on Thursday, Rep. Jack Metcalf, R-Wash, introduced a bill authorizing the Federal Reserve Board to pay interest on reserves. Senate Banking Committee Chairman Alfonse M. D'Amato has promised to hold a hearing on the issue this fall. Fed Chairman Alan Greenspan supports paying interest on reserves. Bankers are not holding their breath. Rather than leaving cash interest- free at the Fed, they are using sweep accounts to significantly reduce required reserves. Reserves on balance have fallen from $27.4 billion in 1994 to a projected $10.8 billion this year. Many economists expect the level to fall to $5 billion next year. This precipitous drop has some policymakers at the central bank worried, because the Fed uses the market for overnight loans of reserve balances to influence other interest rates. The smaller this market is, the more difficulty the Fed has in keeping rates steady. According to the new ABA study, the 50-basis-point spread between the 5.5% rate the Fed would pay on deposits and the 6% it would earn investing required reserves in Treasury securities would result in $1.7 billion in net earnings over five years. Without a change in the law, required reserves kept with the Fed would drop to $4 billion. The Fed, by investing those balances, could earn $1.27 billion. That is about $500 million less than it would earn if it paid interest to attract more reserves. The government would lose money if paying interest did not spur banks to increase reserve levels. Adoption of a bill allowing the Fed to pay interest depends upon the ABA's numbers holding up to further scrutiny, observers said. "It has a good chance if you have resolved the budget effect," said Gil Schwartz, a partner at the Washington law firm of Schwartz & Ballen. "At that point it becomes revenue neutral, and on the merits it has a lot of active support."