Make banks use T-bills as collateral for excess reserves
Minutes from the Federal Open Market Committee’s June meeting show that the Fed is considering allowing banks to use collateral such as Treasury bills for excess reserves.
The Fed would essentially set up a repo facility that results in banks simply posting T-bills instead of cash for excess reserves. The minutes reveal a number of pros and cons with this approach. But in this process, the Fed should require banks to post T-bills for excess reserves above $20 billion.
There has been a lot of discussion regarding how much excess reserves is desirable given that before the last financial crisis, excess reserves were small. Essentially, there was only “required reserves” and banks with a little extra would lend it to those that wanted or needed a little more. The overnight rate charged between banks was kept in line with the target Fed funds rate by injecting or removing liquidity as necessary.
With the current large supply of excess reserves, the actual fed funds rate would plummet towards zero if the Fed was not propping up the rate by making excess reserves valuable by paying banks interest on those reserves. Since the financial system was awash with liquidity from Quantitative Easing, there was little need for lending between banks. And the quoted Fed funds rate stayed exactly the same as the rate being paid on excess reserves.
Recently, the Fed funds rate has moved slightly higher than the rate paid by the Fed. Presumably, this means that there are finally some banks that see growth opportunities and could use additional reserves. To borrow money from another bank, they would need to pay a rate that is higher than what the Fed is paying.
With $1.4 trillion in excess reserves, it might seem a little surprising that banks are in any need for liquidity. However, excess reserves are concentrated among just a few large banks, forcing the rest of the banking industry to borrow from those banks.
One advantage of requiring banks to use collateral for excess reserves over $20 billion is that it keeps the actual Fed funds rate from popping above the target rate when a bank looks to borrow money from another bank; since they are no longer competing against the rate the Fed is paying on excess reserves. This means the rate banks would need to borrow at must be higher than the yield of T-bills to remain competitive.
Another advantage to banks buying T-bills with excess reserves cash is that it lowers the yield on T-bills and encourages banks to earn higher yields by lending the money rather than parking cash at the Fed, resulting in a stimulus for the economy. Lower T-bill yields also helps steepen the yield curve and reduce the perception of a looming recession due to the inverted yield curve.
Reducing the amount of excess reserves that the Fed pays interest on also essentially saves taxpayers a few billion dollars by limiting the potential of the Fed subsidizing the profits of large banks.
The $20 billion cutoff for how much in excess reserves that banks would receive interest on from the Fed versus how much of the reserves consists of T-bills can be adjusted to keep the actual Fed funds rate within the target range.
But the market will likely self-correct as well. Specifically, if the T-bill rate falls far below the interest paid on excess reserves, banks using T-bills for collateral will likely significantly reduce excess reserves. This would push the actual Fed fund rate higher. And the Fed would ask the handful of affected banks how they might adjust their excess reserve balances under this policy to confirm the most likely result.
However, if the actual rate stayed below the target range for too long, the cutoff level could simply be raised to as high as it needed to be. Indeed, the policy could be implemented slowly, beginning with a very high threshold that only moves a couple hundred billion dollars into T-bills initially.
Lastly, the Fed should use a blended policy of paying interest on excess reserves and requiring banks to use T-bills as collateral for a portion of excess reserves. This will help give the Fed further insight into the optimal level of reserves needed within the financial system by observing an actual Fed funds rate that can move both above and below the interest paid on excess reserves.