This Is Why the Fed Is Paying Interest to Big Banks

Q&A on a Fed practice that mystified congressmen today.

Key Takeaways From Janet Yellen's Comments

Federal Reserve Chair Janet Yellen ran into a bipartisan buzzsaw today over why the Federal Reserve is paying interest to banks on the trillions of dollars in reserves that they hold at the Fed. She tried repeatedly to supply the central bank's reasoning but didn't seem to make a dent.

"Please, please explain," Representative Maxine Waters (D-Calif.), the ranking Democrat on the House Financial Services Committee, said at one point. Committee Chairman Jeb Hensarling (R-Texas) said the Fed's interest-paying policy "can distort resource allocation and constrain economic opportunity."

In the heat of a presidential campaign in which candidates from both parties are going heavy on the big banks, the Fed policy of paying them interest on their so-called excess reserves was bound to come in for extra scrutiny. Last year, Waters said, the Fed paid about $7 billion in interest to banks, including more than $100 million to Goldman Sachs and more than $900 million to JPMorgan Chase. And since the Federal Reserve's board of governors voted in December to double the interest rate on those reserves to half a percent from a quarter percent, the payments will be even higher in 2016.

Here's an explanation of the Fed's position, which didn't exactly come through in the sound bites under the bright lights of a congressional hearing.

What are reserves, anyway?

The Fed doesn't let banks lend out every dollar that they receive in deposits. That would be too risky. It requires them to keep 10¢ of every dollar either in their vaults or on deposit at one of the 12 regional Federal Reserve Banks, which are in such cities as New York, Cleveland, and San Francisco. Those deposits are known as required reserves.

What are excess reserves?

Excess reserves are ones that banks hold in excess of the ones the Fed requires (obviously). At last count, a little more than 93 percent of bank reserves were excess. In January, excess reserves totaled about $2.3 trillion. 

Why so much "excess"?

During and after the financial crisis, the Fed bought trillions of dollars in Treasuries and mortgage-backed securities. It didn't pay for them with wads of bills. Instead, it simply credited the sellers of the securities with bigger reserves at the Fed. So now banks have way more reserves than they could possibly use.

And that's a problem?

Yes, because the Fed can't conduct monetary policy the traditional way. In the past, if the Fed wanted to push up interest rates, it would sell a bunch of Treasuries. Banks would pay for the Treasuries by using money in their reserve accounts. That would leave them short on required reserves. To replenish their reserves they would borrow reserves from other banks at a well-known interest rate: the federal funds rate. That won't work any more because the banks have so much in excess reserves that any Treasury purchases they made wouldn't make a dent in the total.

So why exactly is the Fed paying interest on excess reserves?

As a way to raise short-term interest rates, to keep the economy from inflationary overheating. The idea is that if banks can stash money at the Fed at 0.5 percent interest, they won't lend to anyone else for less than that. The rate sets a floor on market rates. (Not a hard floor, because some lenders aren't eligible to earn the Fed's rate, but that's the general idea.)

Why doesn't the Fed just go back to the old way of doing things?

Because it can't do so without getting rid of all those excess reserves that render ordinary monetary policy ineffective. The only way to go back to the old way would be to sell trillions of dollars in securities back to the market. As Yellen told the House committee, attempting such a massive sale right now "would be very disruptive to the economy."

Doesn't paying interest on excess reserves encourage banks to hoard reserves?

The banks don't really decide how much reserves they have. The Fed controls the level of reserves by buying and selling Treasuries and other securities. (That's how reserves got so big in the first place.) So, no risk of hoarding.

But is it fair for the banks to be getting all those interest payments?

That's debatable, but here's the case: The Fed is earning interest on all those Treasury bonds it owns. So much interest that it's been forking over about $100 billion a year in profits to the Treasury each year, which helps narrow the federal budget deficit. You can think of the interest on excess reserves as the Fed's payment for the assets it bought. If it didn't pay any interest on reserves, it would essentially be getting those assets for free. Which also seems a bit unfair.

Couldn't this get pretty expensive?

The Fed earns an average of 3 percent on its assets. If it raised the interest rate on excess reserves above 3 percent, it would start losing money. On the other hand, if the economy is strong enough for the interest rate on excess reserves to get that high, the rate of return on the Fed's assets would probably also be rising, balancing things out. "To not pay IOER [interest on excess reserves] would be basically one degree removed from not paying interest on the Treasury obligations," says Michael Feroli, chief U.S. economist at JPMorgan Chase.

Wouldn't you expect a JPMorgan guy to say something like that?

Says Feroli: "That's an ad hominem argument."

(Updates to clarify the total excess reserves in the sixth paragraph.)
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