WASHINGTON - Is it time for the Federal Reserve to lend banks a helping hand by paying them interest on the reserves they must set aside to protect depositors?

The idea is not a new one and it is one that Fed Chairman Alan Greenspan and his colleagues at the central bank have favored for years.

It is also a controversial proposal. Last year it would have meant taking at least $700 million out of the $17 .4 billion that the Treasury Department received from the Fed's earnings on its huge holdings of securities and other operations. That may not sound like a big bite, but in the past Congress and the Treasury have fought against any reduction in the payments from the Fed.

Joshua Feinman, a senior economist with the Fed's division of monetary affairs, argues that if banks got market-based rates on required reserves they would have income to help pay for the burgeoning paperwork spawned by congressional banking legislation. That, in turn, would free up money for loans to the small and medium-size businesses that are suffering the most from the credit crunch.

"It may be these borrowers who ultimately pay much of the price of the higher, government-mandated costs" on depository institutions, Feinman writes in the June issue of the Federal Reserve Bulletin. "Paying interest on required reserve balances would be one way of offsetting some of these higher costs."

Despite a host of initiatives, first by the Bush administration, and now by the Clinton administration, the credit crunch continues to dog many small businesses. "There have been signs that the economy in general is improving," said Rep. John J. LaFalce, D-N.Y., chairman of the House Small Business Committee, at a hearing last week. "But credit is still not flowing as it should."

Bank loans to business were down 14%, or $68 billion, in the two-year period ending in March, LaFalce said. Economists say the falloff hurts small businesses the most, because this is the sector that depends on banks for loans. Bluechip companies can raise billions on their own in the corporate bond market or by issuing new stock. Meanwhile, mortgage and credit-card financing remains readily available to consumers.

To maintain safety and soundness of the banking system, banks are required to hold a fraction of their deposits in reserve as vault cash or as non-interest bearing balances at the Federal Reserve.

Most banks are able to meet the reserve rules with vault cash, which they hold to meet the daily needs of customers and would likely set aside anyway. But about 3,000 depository institutions are unable to meet reserve requirements with cash alone and have to maintain reserve balances at the Fed.

Feinman calculates that depository institutions, mostly commercial banks, had required reserve balances of $23.5 billion in the fourth quarter of 1992. Assuming the current federal funds rate of 3%, commercial banks are forgoing about $600 million in annual interest payments, and thrifts another $100 million.

If interest rates rise, the so-called reserve tax on banks in the form of forgone interest payments would also go up. But so would the cost to the Treasury, and so would Fed earnings from the central bank's securities portfolio.

The Fed's policy of lowering short-term rates since 1989 has helped banks improve their balance sheets by lowering deposit costs. In addition, the Fed slashed reserve requirements in December 1990 and again in April 1992. Feinman says these moves translated into an increase in pretax earnings of about $1.15 billion.

In the past, opponents of allowing the Fed to pay interest on reserves have argued that banks already get a subsidy from the government in the form of deposit insurance and the readiness of the central bank to step in and protect large institutions from bankruptcy - the too-big-to-fail doctrine.

But Feinman says the additional costs to banks from recent banking laws are a significant factor in reducing the banking industry's traditional role as lender.

Paying interest on reserves would mean only a slight boost in bank aftertax earnings and would not be a panacea for the credit crunch, he says, but it would help.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.