Fed eyes interest on excess reserves changes for certain banks

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WASHINGTON — The Federal Reserve published an advance notice of proposed rulemaking Wednesday seeking comment on whether it should offer different interest rates to different types of member bank reserves and different kinds of member banks to combat “pass-through” entities.

“These narrowly focused depository institutions … could attract a very large quantity of deposits from institutional investors, yet at the same time avoid the costs borne by other depository institutions,” the Fed said in a press statement. “The [notice] requests comment on the potential benefits and potential costs associated with the presence of such institutions in the U.S. financial system and their receipt of [interest] on their balances at a Reserve Bank.”

Since 2008, the Fed has paid interest on banks’ member account balances at a rate set by the Federal Open Market Committee. That interest rate has effectively been the committee’s primary monetary policy tool since the financial crisis, and Fed Chairman Jerome Powell confirmed in January that it would remain so for the foreseeable future.

But the practice has been controversial, with academics and politicians contending that the practice amounts to a giveaway to big banks at the expense of the rest of the economy.

The notice said that the Federal Reserve Act gives the agency the authority to pay interest on both required reserves — that is, minimum balances that Fed member banks must maintain within the Fed system — and excess reserves, which are additional balances that the banks keep in their Fed accounts by choice. But the Fed has the power to distinguish between required and excess reserves, as well as between depository institutions, when it considers what interest rates to pay on reserves.

The problem that the agency appears to be hoping to solve with a future rule is the emergence of so-called pass-through investment entities, or PTIEs. PTIEs are formed when a financial institution acquires a state bank charter for the sole purpose of accepting large quantities of deposits from institutional investors and parking those deposits in a Federal Reserve Bank account and accruing interest. The PTIE then passes that interest back to the nonbank institutional investor, less some nominal fee.

By effectively passing on the higher Fed member bank interest rate to nonbanks, the Fed said PTIEs could make it harder for the Fed to enact monetary policy by reducing the spread between IOER and overnight repurchase agreements. PTIEs also potentially gain the benefit of Fed membership in the form of interest on excess reserves, but without the capital constraints or public benefits of lending, the Fed said.

“The board is concerned that PTIEs … have the potential to complicate the implementation of monetary policy,” the Fed said. “In addition, the board is concerned that PTIEs could disrupt financial intermediation in ways that are hard to anticipate, and could also have a negative effect on financial stability.”

The Fed said that it would take comment on how it ought to address these concerns, but offered a handful of options itself. The first would be to articulate a definition of PTIE — either by ratio of capital to deposits, a threshold or proportion of assets that are Fed deposits, or by whether the institution is overseen by a federal banking regulator. And once PTIEs are defined, the Fed sought comment on how to pay interest to them differently than to traditional banks — either with zero interest on excess reserves, zero interest beyond a certain threshold, or some other formula.

But the agency noted that however it addresses PTIEs, its goal is not to change the way it pays interest on excess reserves for traditional member banks.

“In all of these alternatives, the board expects that it would define PTIE such that the vast majority of existing eligible institutions would continue to be paid the current IOER rate on all of their excess balances,” the Fed said.

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