A shift in the game of arbitraging interest on balances booked at the Federal Reserve could be under way.

Cash held by domestic banks has tripled since the middle of 2008 to 9% of total assets as the Federal Reserve has injected trillions of dollars into the economy. However, the surge at foreign-controlled entities has been far greater — cash levels increased almost tenfold during the same time to about 45% of total assets (see charts).

Much of the money is essentially deployed in a play on the difference between the rate the central bank pays on reserves — 25 basis points since December 2008, when the Fed adopted its near-zero target for the rate on overnight lending among banks — and other short-term rates. (The Fed started paying interest on reserves in October 2008 in order to have a tool to lift rates despite the extraordinary liquidity in the banking system created by its rescue programs.)

Now, however, wavering confidence in European banks is spurring investors to trim funding extended to them, and appears to be channeling reserves to domestic institutions. Cash levels at foreign-related institutions retreated a bit in June, while cash levels built at domestically chartered banks.

Despite the tremors so far, foreign entities appear to be left with enormous holdings of reserves. It is a rough approximation at best, but based on their share of total cash on bank balance sheets, the group could account for half of bank deposits at the Fed.

In a report in July, Joseph Abate, an analyst at Barclays Capital, estimated that the share was much higher — about two-thirds of the roughly $1.5 trillion in bank reserves currently outstanding.

Money market funds are a key element in the arbitrage. They purchase commercial paper issued by foreign banks (three-month obligations of financial companies yielded about 13 basis points during the week that ended July 22), and the banks park the proceeds at the Fed.

U.S.-owned institutions accounted for only about 22% of the roughly $534 billion of financial commercial paper outstanding at the end of June, down from about 40% of $795 billion at the end of 2009

To be sure, there is nothing illicit about earning interest on reserve balances. The record amount of reserves outstanding is largely a byproduct of the securities the Fed has amassed under its quantitative easing program, which was designed to hold down borrowing rates and boost asset prices, and they provide much-needed liquidity buffers for a banking system that has been chronically threatened by crisis.

Moreover, the most recent European bailout package — announced in late July — could lastingly ease concerns about banks on the Continent. Also, political dysfunction in the U.S. seems to have upstaged dysfunction across the Atlantic, and gridlock over the debt ceiling is probably the stronger force behind money flows now.

Still, to the extent that some of the arbitrage trade is moving to domestic banks, it is likely unwanted, Abate wrote.

(Only banks can hold reserves, and the Fed principally controls the total level of reserves, for instance by buying and selling securities from banks. Thus, if reserves held by foreign-related institutions fall, they more or less must rise at domestic banks.)

Many of the foreign-related institutions are not a part of the deposit insurance safety net, while bigger balance sheets subject domestic banks to larger insurance assessments.

Given the slim gap between the rate the Fed pays and other short-term rates, Abate wrote, such cash "may even earn a negative return."

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