Is it time for the Federal Reserve to lend banks a helping hand by paying interest on the reserves they are required to set aside to protect depositors?

The idea is not a new one. Fed Cahairman Alan Greenspan and others at the central bank have favored it for years.

But it is controversial because it would mean the Fed's earnings from securities and other operations would decline, and so would the payments each year to the Treasury.

On the other hand, banks' income would rise.

Joshua Feinman, a senior economist with the Fed's division of monetary affairs, argues that market-based rates on required reserves would help offset, the rising costs of the paperwork spawned by congressional banking legislation.

That, in turn, would make it easier for banks to lend to the small and the medium-size businesses that are suffering most from the credit crunch.

"It may be these borrowers who ultimately pay much of the price of the higher, government-mandated costs on depositories," Mr. Feinman wrote in the June Federal Reserve Bulletin. "Paying interest on required reserve balances would be one way of offsetting some of these higher costs."

Despite a host of initiatives dating back to the Bush administration and continuing under President Clinton, tight credit continues to dog smaller borrowers.

"There have been signs that the economy in general is improving," Rep. John LaFalce, D-N.Y., chairman of the House Small Business Committee, said at a hearing last week. "But credit is still not flowing as it should."

Bank loans to business were down 14%, or $68 billion, in the two-year period ending in March, Rep. LaFalce said.

Small Firms Hurt Most

Economists say the small-business sector has been hit hardest because it depends on banks for loans. Larger, bluechip borrowers have been able to raise billions of dollars by going to the financial markets on their own. Meanwhile, mortgage and credit card financing remains readily available to consumers.

Most banks are able to meet the reserve requirements which are fractions of deposits that are set aside to ensure safety and soundness - with the vault cash that they keep available for customers.

But about 3,000 depository institutions do not meet the requirements with cash alone and have to maintain balances at the Federal Reserve Banks.

Mr. Feinman calculates that depository institutions - mostly commercial banks - had reserve balances of $23.5 billion in the fourth quarter of 1992. Assuming the current federal funds rate of 3%, commercial banks are forgoing about $600 million in annual interest income, and thrifts another $100 million.

Relatively Small Sum

The Fed would have no problem paying $700 million in interest. Last year, the central bank turned over $17.4 billion in earnings to the Treasury.

When interest rates rise, the so-called reserve tax on banks - the forgone interest payments would go up accordingly. But so would the cost to the Treasury. as would Fed earnings from the its securities portfolio.

The monetary policy that has lowered short-term rates since 1989 has helped banks improve their balance sheets by lowering deposit costs.

In addition, the Fed slashed reserve requirements in December 1990, and again in April 1992. Mr. Feinman said these moves translated into an increase in pretax earnings of about $1.15 billion.

Other Subsidies

Opponents of interest on reserves have argued that banks already get a subsidy from the government in the form of deposit insurance and a readiness by the central bank to step in and protect large institutions from bankruptcy - the too-big-to-fail doctrine.

But, Mr. Feinman said. the additional costs to banks from recent laws are a significant factor in reducing the industry's traditional role as lender.

Relief in the form of interest payments on reserves would not be a cure-all, but it would give a small boost to after-tax bank earnings and help the credit crunch, he said.

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