The banking industry has suffered a setback in its crusade for legislation allowing the Federal Reserve to pay interest on required reserves.

New estimates from the Congressional Budget Office peg the move's cost at $1.2 billion over 10 years. The finding sharply contradicts an analysis by the American Bankers Association, which said in July that the government would earn about $1 billion in 10 years paying interest on reserves.

Still, the CBO price tag is significantly less than prior government estimates, which put the cost at more than $500 million a year.

Reserve balances have become a hot political issue for bankers, who complain that they lost more than $700 million in 1996 by keeping reserves in interest-free accounts.

"It is only fair for us to receive interest on our investment," said Michael E. Grove, president of First National Bank of White Sulphur Springs, Mont. "These are monies that the Treasury is using and we are not."

Most large banks have created elaborate sweep programs to cut their losses. These systems periodically transfer cash in corporate checking accounts to money market accounts, which are not subject to the Fed's 10% reserve requirements.

Fed officials have warned that these moves have led to a precipitous decline in reserves that could hurt the central bank's ability to control the economy. The Fed manipulates short-term interest rates via the overnight credit market for excess reserves. The fall in reserves has made this market more volatile, making it harder for the Fed to keep rates steady.

Rep. Jack Metcalf, R-Wash., introduced a bill in July authorizing the Fed to pay interest on reserves and giving banks permission to pay interest on business checking accounts. Senate Banking Committee Chairman Alfonse M. D'Amato also has pledged to support paying interest on reserves.

The CBO estimate does not appear to have weakened congressional support for paying interest on reserves.

"Chairman D'Amato plans to press ahead," a spokesman for the New York Republican said Wednesday. "This is an important matter of public policy."

"We are not worried," an aide to Rep. Metcalf said. "Considering where we were a year ago, this is amazing. No one can believe that they (the cost estimates) are this low."

Arnold Cohen, a legislative specialist for America's Community Bankers, said he expects CBO will produce an even lower estimate within a few months because the Fed and trade groups are sending updated data on reserve accounts. "We are close to making it budget neutral," he said.

Edward L. Yingling, the ABA's chief lobbyist, said the industry's fight is doomed unless CBO revises its estimate.

"Any negative scoring is going to present a real political problem," he said. "It means lawmakers have to offset it, which means they have to find something else in the Banking Committee to cut or some other way to raise revenue."

But Gil Schwartz, a partner at the Washington law firm of Schwartz & Ballen, said he expects lawmakers will support the bill, even if CBO doesn't change its estimate.

"This is only a modest additional cost," he said. "The numbers are well below prior estimates and they seem very modest compared to the cost of having it be more difficult for the Fed to conduct monetary policy."

CBO examined the effect on government revenue of both a change in the law and the status quo. The agency then adjusted its findings to account for taxes. The result is losses of $260 million and $115 million in 1998 and 1999, respectively. Losses then would drop to $90 million before rising slowly to just over $100 million annually through 2007.

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