WASHINGTON — As the 2016 presidential election season heats up, candidates on both sides of the aisle are questioning the Federal Reserve's policy of paying interest on excess reserves to member banks, calling it a giveaway to Wall Street.
It "keeps money out of the economy and parked at the Fed," Sen. Bernie Sanders declared in a speech this month. Sen. Rand Paul, R-Ky., said a week later that the Fed's stance "exacerbates income inequality" and noted that the central bank wasn't even allowed to pay interest on reserves until a decade ago.
"While individual savers earn practically no interest — the big banks are given $12 billion in interest," Paul said.
Fellow Republican presidential hopeful Sen. Ted Cruz, R-Texas, similarly questioned the amount of money banks have received on reserves.
But the bipartisan suspicion of the Fed as somehow surreptitiously funneling money to Wall Street by way of interest payments represents a fundamental misunderstanding of how interest on excess reserves works and how monetary policy is conducted.
Congress Gave the Fed the Power to Pay Interest on Reserves for Logistical Reasons
Congress originally authorized the Fed to pay interest on reserves as part of the Financial Services Regulatory Relief Act of 2006, a bill signed by President Bush and engineered by the Republican-controlled Congress with input from congressional Democrats. The bill stipulated that the authority would not go into effect until October 2011.
The initial rationale for IOER was that it would end a nearly century-long practice of not paying interest on required reserves — a policy that banks considered an implicit tax. But interest on reserves would also serve a secondary purpose of aiding in monetary policy implementation.
Prior to IOER, banks had a longstanding practice of stashing excess cash balances in money markets, overseas or in other accounts not subject to Fed cash reserve requirements — precisely because such reserves bore no interest, while those various cash markets did.
Allowing the Fed to pay interest gave banks a reason to consolidate those balances within the central bank system. That in turn gave the Fed a key monetary policy lever, because whatever interest rate the Fed offered on reserves would act as a kind of "floor" for offered rates elsewhere in the economy.
Up until that time, the Fed influenced interest rates through relatively small open market operations — buying or selling Treasuries or conducting reverse repurchase operations in the order of a few billion dollars. By setting rates via interest on excess reserves, the Fed could target rates more precisely, playing a benchmarking role that had largely been played by the overnight cash interest rates that banks would offer to one another — usually in the form of the now-discredited Libor interest rate, which was secretly manipulated by the banks for years.
In other words, interest on excess reserves was engineered to take what had been an imprecise and complicated monetary policy process and replace it with a more effective one that was simpler to execute by gradually giving the Fed more precise control over cash reserves.
But the 2008 financial crisis created an emergency that required Congress to implement the Fed's IOER authority immediately in order to preserve the Fed's control over short-term rates. Banks simply stopped lending to one another, so the interbank overnight market — along with its interest rate benchmarking function — disappeared. Congress responded by accelerating the implementation of interest on bank reserves to Oct. 1, 2008 as part of the bill that authorized the $700 billion Troubled Asset Relief Program. The Fed set its first interest rate on excess reserves within days of the bill's passage and it went into effect on Oct. 9.
Reserve Banks Balances Represent Fed Debt, Not Bank Cash
A frequently cited figure that IOER opponents cite to illustrate the wastefulness of interest on excess reserves is the size to which those bank balances have grown since the policy was enacted eight years ago — exceeding $2.4 trillion, according to Sanders (it is actually slightly lower, around $2.33 trillion). Equally eye-popping is the speed in which those balances have grown since interest was first offered — $800 billion in January 2009, $1 trillion in January 2010, $1.5 trillion in January 2012, and reaching $2.4 trillion in January 2014, where it has remained since, give or take.
But whereas Sanders suggests that this money represents the amount of cash that banks are voluntarily keeping out of the economy because the interest rate offered by the Fed is so sweet, that figure more accurately corresponds to the size of the Fed's balance sheet.
When the Fed began its policy of "quantitative easing" in 2008 — that is, buying securities and other assets from the banks in order to stimulate the economy — the Fed paid for those assets by crediting the banks' reserve accounts. To be sure, the excess reserve figure is not a perfect representation of the Fed's balance sheet because it consists of more than just assets the central bank bought from banks. But the jump in excess reserves since 2008 roughly corresponds to the rounds of quantitative easing.
To be sure, banks have a role in how much money they put into their Fed accounts. But they have no say in how big the aggregate size of the reserves held in the Fed system would be. This is because the Fed system is a kind of closed loop — any number of dollars that a bank would take out of its reserve account and lend, spend, park or otherwise distribute would be dollars that would show up elsewhere in the economy and thus in some other bank's reserve account, thus keeping the overall aggregate size of all bank balances the same.
That balance can go down, but only when the Fed draws down its balance sheet as the assets it bought reach maturity — a policy that the central bank has so far held off on but has said it intends to do as it normalizes monetary policy over time.
The Interest Rate on Excess Reserves is the Worst Return Banks Can Get on Their Money
One way of thinking about the evolution of interest rates on excess reserves as a monetary policy lever is to consider that the Fed's rate is meant to serve as the "floor" for all other rates — in other words, the worst return on money available in the economy. Former Fed Chairman Ben Bernanke said in a speech in January 2009 that "in principle" banks "should be unwilling to lend reserves at a rate lower than they can receive from the Fed."
To be sure, the federal funds rate falls in a band between what banks receive in interest on their reserves, currently 50 basis points, and what other market participants receive via overnight reverse repurchase agreements with the central bank, currently pegged at 25 basis points. In that way the interest rate on reserves acts as a ceiling rather than a floor in the market for wholesale funding. But banks operate in far more markets — markets with much better returns — than the risk-free market for overnight cash. And when banks do lend, which accommodative monetary policy is designed to encourage, they lend at rates higher than the 50 basis points they receive from the Fed.
There have been some suggestions that there should be no discrepancy between the returns that repo recipients, which are primary dealers in securities, certain money funds, the Federal Home Loan banks and government-sponsored enterprises, should receive and the interest rate on reserves that is given to banks. But eliminating that spread would needlessly dismantle the existing overnight cash market and give the Fed and other regulators little insight into market demand.
Even if Interest Rates on Reserves Are Higher than the Federal Funds Rate, It's Not a Bank Giveaway
The pool of excess reserves that the Fed is paying interest on is essentially a representation of what the Fed paid for the securities, Treasuries, and other various products to stimulate the economy. Those securities remain on the Fed's books and continue to generate income — more than $100 billion in 2015. Most of that balance goes directly to the Treasury, but some goes back to the banks in the form of interest rates for excess reserves — roughly $12 billion, according to Paul.
Considering that most banks would rather be making $100 billion than $12 billion, the banks themselves don't think of interest rates on reserves as a giveaway. Rather, they view it as a neutral means of having their excess reserves tread water until they find a better place to spend it. The purpose of paying interest on reserves was to end a nearly century-long practice that essentially treated reserve requirements as a tax.
Banks can choose to put more or less of their reserves into their Fed accounts. Perhaps they are hoping to keep a large position liquid for some strategic purpose. But banks in general do not deploy their assets to the Fed system because it is the highest return available on their money. And the banking industry as a whole could not get out of the Fed system if it wanted to, because they can only hold the amount of reserves that the Fed itself supplies.
Eliminating the Fed's Ability to Pay Interest on Excess Reserves Would Be a Terrible Idea
Eliminating interest rates on reserves at this point could be catastrophic. With no power to influence banks with interest on excess reserves, the Fed would have to create an entirely new means of implementing monetary policy. The immediate effects of such an alternative policy would mean that the central banks would have to adopt a much more aggressive schedule of reducing its balance sheet and almost certain financial disruption.
The Fed's earlier small open market operations would be meaningless since the volume of excess reserves is so large, and the central bank has no capacity or appetite to conduct open market operations of a commensurate size to influence the wholesale funding markets. Even if it did, doing so would be far more problematic than paying interest on reserves.
And even if that power were abolished, the banks that would be hardest hit would be smaller and medium-sized banks that have accounts with the Fed. Those banks — unlike large banks that are also primary dealers in securities — would not have the option of simply shifting over to the repo market.
Painting interest on excess reserves as a crooked scheme to hand money to big banks may be politically expedient, since the agency is unpopular and poorly understood and big banks are an easy target. But actually eliminating the Fed's power could wreak economic havoc — and trigger another financial crisis.
John Heltman is a reporter for American Banker. The views expressed are his own.