Fed Does Not Owe Banks Interest

There are many ways in which regulations should be modified to help the banking industry recover, but the popular request that the Federal Reserve pay interest on the reserves banks leave with it is misguided.

Sure, it would provide a nice bonus to the banks. At present, the Fed reports that banks have just under $50 billion in required reserves. If we estimate that $10 billion of this is in currency, banks hold about $40 billion in deposits at the Fed which earn nothing. If the Fed paid interest on this money, say at 6% per year, banks would have $2.4 billion more a year in income than they do now. Not a bad sum.

But the fallacy is in thinking that banks leave money at the Fed in sterile form when they could otherwise put it to work. In reality, our system lets banks create money. Part of that money the Fed forces banks to keep on reserve. This is done to limit expansion of the money supply so that it is consistent with what the nation needs to finance non-inflationary growth.

Ancestral Goldsmiths

Let's look at the goldsmiths, the first banks. Goldsmiths kept gold in safekeeping for people, giving them certificates to prove their gold was on deposit.

To avoid having to go back and forth to Max, the goldsmith, people started to spend the certificates and leave the gold with him. But Max still had 100% in gold reserves backing his certificates.

Then one day, someone came in and wanted to borrow gold. Max reflected, "People come in with gold and take out certificates, and others come in with certificates and take out gold, but every night I have some gold left and some certificates outstanding.

"Since this man wants to borrow gold, and he will pay me interest for it, who is to know if I have more certificates than I have gold?"

As soon as Max passed out more certificates than he had gold, the first bank was born.

How could Max do this? because people spent his liabilities, his certificates, as money. If they had not accepted them as money, his shop would have been just a safe deposit vault.

Commercial banks are the same. When people come in to borrow money, the banker gets a couple of signatures and that's it.

A customer signs one piece of paper giving him a deposit, meaning the bank has lent him money, and another piece of paper indicating that he owes the bank money, a loan. The only reason he pays the bank for its loan rather than the bank paying him for the loan he has given the bank (the money he keeps in the bank) is because people call the bank's debt spending money - demand deposits - while the debt of the borrower is not considered as such.

The bank has created deposit money, but it needs reserves in cash or deposits at the Fed to back this new deposit. Bankers might ask, Isn't this real money that the banker had to obtain through sweat and blood, and not money it created out of thin air? Also, isn't the banker prevented from creating deposit money?

And when the borrower spends the proceeds of the loan, doesn't the created deposit go to some other bank, and doesn't the bank that made the loan have to cover the full amount lent with cash or a deposit that it has at the Fed - something it cannot create out of thin air?

Solid Backing

To be sure, the banker needs actual cash at the Fed to back the deposit money he has created. This can only be obtained by having investors provide real money as equity or by obtaining deposits that are not created, deposits that must be paid for with interest or services such as check clearing operations.

But the real deposits that serve as reserves are only a small fraction of the deposit the bank has created in making the loan. And it is a cheap price to pay for the privilege of creating 15, 20, or 25 times as much new deposit money as you left real money with the Fed.

Certainly, the banks have to cover the full amount of the money they have created with actual reserve outflows as the borrower spends his proceeds and the money goes to another bank. But at the same time, this bank, under the law of averages, is itself getting a new deposit of money that some other bank has just created. It is getting a deposit at the Fed of 100% of the amount deposited just as it loses 100% of the amount it lent out.

Generous to a Fault

For the Fed to pay interest on these reserves on top of letting them serve as the basis for creating deposit money would be overly generous.

Further, if the Fed were to pay interest on deposits that banks keep as reserves, the money would come from the profits the Fed turns over to the Treasury every year. In effect, this would be a gift from the taxpayers to the banks.

Once the public understood what was happening, there would be a tremendous outcry - one that would cost the industry far more than $2.4 billion in good will, congressional support, and other legislative benefits.

Mr. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.

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