WASHINGTON — With a credit crunch gripping the industry, bankers looking to stash money in a safe place have been shoveling funds into the Federal Reserve, where excess reserving reached an average of $68.8 billion between Sept. 11 and Sept. 24.
That was up from an average of just $2.26 billion two weeks earlier, from late August to mid-September. In fact, before last month the highest excess reserves — money beyond the amount banks must keep on account at the Fed — reached all year was $2.99 billion in March.
But that is likely to change, because the Fed said Monday that it will begin paying interest on both excess and required reserves. The Fed is essentially calling on banks to give it more money, expanding its balance sheet and, in the process, its ability to support increasingly large liquidity programs.
"This gives the banks an additional safe haven for their funds," said Bob McTeer, a distinguished fellow at the National Center for Policy Analysis and the former president of the Federal Reserve Bank of Dallas. "It also helps the Fed's ability to pump liquidity into the system."
Beginning Thursday, the Fed will pay banks 10 basis points under the federal funds rate, or 1.9%, on reserves held to meet regulatory requirements. For excess reserves, the rate is 75 basis points below the fed funds rate, or 1.25%.
Under the Monetary Control Act of 1980, the Fed is allowed to take between 8% and 14% of transaction deposits to satisfy reserve requirements. The central bank held $6.983 billion in required reserves between Sept. 11 and Sept. 24.
The Fed strongly lobbied Congress to change rules that barred the central bank from paying interest on reserves. Congress agreed to do so in the 2006 regulatory relief law but said the Fed could not begin paying the interest until October 2011. The Fed asked Congress to move that date up, and it complied in the economic rescue package enacted last week.
Robert Davis, the American Bankers Association's executive vice president for government relations, said the Fed's decision to begin paying interest will give bankers a much-needed source of interest income. "It immediately changes the attractiveness of holding deposits in the reserve banks."
Expanding its balance sheet will help the Fed meet the growing demand for liquidity through the discount window and other programs. That has become increasingly crucial recently. There was a growing sense of concern last month when nearly half of the Fed's $924.2 billion balance sheet was tied up in liquidity programs on Sept. 10.
That ratio has come under more control recently as the Fed has expanded its balance sheet to accommodate an $85 billion loan to American International Group Inc. and created a lending facility to shore up money market mutual funds.
The Fed said it held $1.498 trillion of total assets on Oct. 1. Those assets are expected to grow as more banks hold reserves at the Fed.
A bigger balance sheet will be particularly helpful since the Fed also announced Monday that it would dramatically expand its periodic cash auctions to $150 billion, from $75 billion. The sales will stay at that level through November, and the central bank said as much as $900 billion of loans could be outstanding at yearend.
Gil Schwartz, a former Fed lawyer who now works in private practice, said the central bank could financially stomach the bigger sales, but he said the expansion serves as another indication of the severity of the credit crunch.
"If anything, it's reflective of the fact that people aren't lending, and you have to go to the Fed now if you want to get money," Mr. Schwartz said.
Though the upcoming auctions are far larger than the $20 billion sales the Fed held when it introduced the program in December, Mr. McTeer said observers should not be concerned.
"If the larger and larger numbers scare you, you've got to remember it's not just money going out there," he said. "It's a loan that gets paid back."
Also Monday, the Fed said that it was waiving rules that limit depository institutions from working with affiliated money market funds.
The rule change clears the way for bank holding companies to provide more direct support to the funds, which have been struggling with a perception of enhanced risk in recent weeks.
