WASHINGTON — To collect more money for liquidity programs and maintain a hold on monetary policy, the Federal Reserve Board essentially asked the banking industry for more cash Wednesday.
The Fed said it will begin paying more interest on the reserves financial institutions hold at the central bank. In most circumstances, required and excess reserve holdings will collect interest at the federal funds rate, currently 1%.
The plan should encourage bankers to send money they would have lent to other banks in the open markets to the Fed instead. The central bank said it is trying to "help foster trading in the funds market at rates closer to the … federal funds rate."
Translation: Some banks, especially small ones, are borrowing in the interbank market at rates much lower than the fed funds rate, and the Fed wants to change that.
"What the Fed is doing is giving it more control over the fed funds rate," said Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial Capital Markets. "They're sopping up liquidity."
That may seem like an odd strategy during a credit crunch, but as the Fed takes more money out of the open market, the effective interest rate for the small banks will rise closer to the Fed's target of 1%. Mr. Low said the rate for these institutions has been 40 basis points below that target in recent days, while the largest banks have been borrowing at more than 1%.
The hike in interest may be more costly for small banks, but it should add to the heft of the Fed's ever-growing balance sheet which, in turn, supports liquidity programs the central bank has used to fight the credit crisis.
The Fed "sees a long term likelihood that they will have to flood the market with liquidity," said Gil Schwartz, a former Fed lawyer who now works in private practice. "This lets them do that more effectively."
Mr. Low said the cash the Fed is attracting from small institutions can be turned around and lent to large ones through programs like the term auction facility.
"If they actually manage to pull a significant amount of cash out of the small-bank market, then they can use that to fund the TAF program to fund the megabanks," he said. "If they soak up enough reserves, it will give them the firepower they need for the big banks."
The Monetary Control Act of 1980 gives the Fed the power to collect between 8% and 14% of a bank's transaction deposits to fulfill reserve requirements. It began paying interest on reserves last month, after Congress gave it the authority to do so in the economic rescue package.
The central bank said Oct. 6 that it would pay 10 basis points below the fed funds rate on required reserves. The original plan also said excess reserves would collect interest of 75 basis points below the fed funds rate.
The Fed altered its formula Oct. 22 to allow excess reserves to collect interest at 35 basis points below the fed funds rate.
The prospect of earning interest — at whatever rate — has proven attractive to bankers. As of Oct. 29 depository institutions' balance with the Fed had grown 87.7% from a week earlier and 137.6% from four weeks earlier, to $425.972 billion.