A question on paying interest on excess reserves came up during Janet Yellen’s recent congressional testimony.
Bloomberg writer Peter Coy offered this Q&A on a Fed Practice that Mystifies Congressmen. However, Coy blew many of the answers.
Coy: 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.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.
“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.”
Coy: 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.
Q: What are excess reserves?
Coy: 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.
Mish: No problem with that answer.
Q: Why so much “excess”?
Coy: 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.
Mish: Essentially correct
Q: And that’s a problem?
Coy: 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.
Mish: Sort of. The Fed could have and should have acted to shrink its balance sheet before it hiked rates in December. Instead, the Fed kept its balance sheet over $2 trillion. Next the Fed waited too long to hike as we have seen, but that is a different issue.
Q: So why exactly is the Fed paying interest on excess reserves?
Coy: 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.)
Mish: The Fed wants banks to lend. It is nowhere close to worrying about the economy overheating. Thus, paying interest on reserves is free money to the banks.
Q: Why doesn’t the Fed just go back to the old way of doing things?
Coy: 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.”
Mish: Perhaps it would be disruptive “now” if done in one massive swoop. But done slowly between 2012 and 2014 as part of its explained policy, the Fed could have and should have drained those securities from its balance sheet. Yellen was quite a bit disingenuous with her answer and Coy failed to notice.
Q: Doesn’t paying interest on excess reserves encourage banks to hoard reserves?
Coy: 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.
Mish: Correct
Q: But is it fair for the banks to be getting all those interest payments?
Coy: 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.
Mish: Quite frankly, that explanation is ludicrous. The Fed does collect interest on its balance sheet but that comes directly from taxpayers as interest on debt. Returning interest the Fed collects to the Treasury only narrows debt to the tune it increased the debt in the first place! The Fed does not return all the interest it collects. Some goes to staff, meetings, research etc. The most galling part of the equation is that instead of returning more money to the Treasury, the Fed gives a huge handout to the banks.
Bonus Mish Question
How big is the free handout to banks?
If excess reserves are $2.3 trillion and the Fed pays interest to banks at 0.5%, then the answer is $11,500,000,000!
That amount will rise every time the Fed hikes until the reserves are drained.
Mike “Mish” Shedlock
I don’t understand any of this logic, which either means I’m dumb or that it’s intentionally convoluted in order to deceive people (I’m betting the latter).
If “The banks don’t really decide how much reserves they have”, the implication is that the FED does; But then why are 93% of the reserves considered “excess”? (Yes, I understand the part about the 10% fractional reserve requirement).
Why not pay interest only on the required reserves and 0% on the excess?
I think these academics delude themselves into thinking that their ideas and economic models are superior, while in fact they’ve become so esoteric that there are flaws embedded at every part of their equations. They are no different from the folks at LTCM. Right, only up until they are disgracefully wrong and burn down the house (and we ALL are living in that house.)
Why can’t we just KISS (Keep It Simple, Stupid!)
If congressmen (who aren’t exactly academically dumb) can’t even understand it, how are they supposed to make wise decisions when they vote on legislation!?
When the Fed expands its balance sheet it creates excess reserves.
That’s simply a mathematical truism.
Mish
So, when the Fed starts up the printing press, do these bank held excess reserves increase?
And the Foreign Banks too.
$11,500,000,000!
Any idea how much the foreign banks are taking ?
.
..
I don’t think we have a breakdown from the Fed but they should disclose it
Mish
The Fed is not “setting a floor” on interest rates by paying interest on excess reserves (IOER), and the rate paid has little to no effect on the rate banks are willing to lend to corporate or individual borrowers. With $2.3 trillion in excess reserves, the only thing limiting banks’ lending is their cost of funds, and finding an entity to lend to at a spread above cost of funds who will actually pay back the loan (and if the bankers can pretend they will be paid back many bank CEOs don’t even much care about a future default, as they will be long gone with their bonuses before the eventual recognition of loan default). The only banks borrowing in the Fed funds market borrow from entities which legally do not receive IOER (e.g. the government sponsored entities or GSEs), and banks borrow Fed funds from them at a rate below the IOER rate and arbitrage the difference.
What does indirectly affect banks cost of funds is the Fed reverse repurchase (RRP) rate (currently 25 b.p.) paid largely to money market funds. This offering of RRPs actually soaks up Fed reserves (though less than $50 billion in the past few days auctions), and the government (t-bills rates), corporations (commercial paper rates), and banks (institutional deposit rates) must compete with what the Fed offers on this rate or all funds would flow to money market funds to get the RRP rate. Because the management fees on money market funds geared to individuals are in excess of the 25 b.p. RRP rate, the Fed’s RRP auctions are not a factor in where individuals hold their liquid funds yet, but if we saw a few more Fed rate increases that would change.
The $11.5 billion paid in IOER is nothing but a giant subsidy to the banking industry, which works out to ~$36 annually at the current 50 b.p. rate for every man, woman, and child in the United States ($11.5 billion/320 million citizens). And bear in mind this is in addition to the artificial gains earned by the banking industry as a result of the Fed lifting prices on treasury and mortgage markets with massive QE.
No institutions that have been recently insolvent requiring a rescue, and that have a continual history of fraud, should be allowed such privileges. The whole system is an obvious fraud.
This money represents the poker chips the TBTF get everytime they pass “go”.
The most fascinating part is how long these clowns have kept this charade going.
The Fed does pay interest rates on reserves to put a floor on commercial rates. The theory is that, in a fractional reserve system with lots of excess reserves, banks can lend out a LOT. That will drive down the cost of money. Banks will not, however, go lower than the reserve interest rate (which is loest risk) + the risk premium for a given investment.
Here’s a good series of questions to ask next time.
Who owns the twelve regional Federal Reserve banks, and exactly what percentage of each of the twelve banks does each of these “member banks” own?
Do these owners receive a 6% dividend every year?
How much money did each owner receive in such dividends for 2015?
Why does the Fed pay this money?
What public purpose do these payments support?
What good does this do?
For a “non-answer” answer, go here: http://www.federalreserve.gov/faqs/about_14986.htm
Shareholders in reserve banks get the dividend because they are required to be market makers for treasury debt. Meaning they will buy it at a reasonable price even if the rest of the market considers it odious. It is payment for the acceptance of risk of major losses if the Feds go full retard deficit wise.
If this 6% dividend is a sort of “put and call” option on Treasuries paid by the Fed to member banks, then should it not be included in the balance sheets and trading records as an option, rather than as an interest payment?
Does not the absence of correct accounting for this money make the rate of interest lower than it would be otherwise? The money the Fed pays lowers risk for the sale of Treasuries but is not paid directly by the Treasury Department. It’s a sleight of hand worthy of a master magician, but it’s also piss poor accounting.
Why is it not accounted for as an option rather than as a mandatory interest payment that is made every year at the exact same rate, despite fluctuating market rates for such options?
Why does not the Fed just sell puts and calls on the open market and let anyone take the other side of the trade, and eliminate the interest payments altogether?
How much money would they save?
They won’t even tell us how much they are paying right now, so I do not expect an answer to that question.
I suspect that the real answer to all these questions is that doing this openly would reduce the ability of the Fed to move in the shadows and manipulate markets, and that would be anathema to the control freaks who run the place.
There are other ramifications.
If the Fed is paying interest on reserves to the banks in the U.S. it is helping monetize the non-performing loans in the economy and to a degree aid in clearance of assets. (hypothetically) realistically most of it probably goes to shareholders and salaries but it does get to increase the leverage ratios making the robustness of the system higher.
From an international standpoint by providing interest on reserves it is soaking up foreign dollar liquidity to the U.S. into Fed reserves. This is probably the ultimate goal nobody mentions. Ramifications of this policy in a dollar debt environment is very interesting. If Turkish banks whom are long term borrowers of dollars in eurobond market sterilize their dollar flows out of the Turkish economy they are aiding in de-dollarizing the debt economy of Turkey. If this is occurring globally then the ultimate question. Why? interbank lending in dollars would be moot so the only access would be provided by swaps by the Fed or exchanges, where margin capital needs to be posted.
If you look at rate increases as pressure globally on returning dollar capital and clearing assets so that the global economy could purge all the crap that is being held back. If dollar capital is destroyed the Fed can print to monetize the assets it purchased from banks before and release reserves into productivity. If it comes back it sterilizes the flows to mitigate fluctuations. I find the amount of perceived control in this scenario to most likely spiral out in a way nobody expects.
Dear Lushfun, I understood your first paragraph, but not the following two. Could you please elaborate on them, maybe showing intermediate steps, for others who are not so economically literate as yourself. Thanks.
And let’s remember that, while the Fed did buy lots of Treasuries, it ALSO bought a bunch of total garbage “assets” at full price, bailing out the banks not once (by giving them the gift of not taking a haircut on their “assets”) but twice by then paying them interest on the “reserves” that they received for the garbage “assets.”
Mish, Didn’t Congress just pass a bill guaranteeing 6 percent dividends on Federal Reserve shares held by member banks? If so could you please elaborate? Thanks.
Where is the part that addresses fractional reserve banking as part of this discussion?
I guess no one is officially questioning usefulness of fraction reserve banking. That’s why it stayed out of the discussion.
Try here: https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr380.pdf
Actually, this paper explains a lot. The problem is not with mathematical market models per se, but with the selection of mathematical models. I think it is easy to incorporate lack of creditworthy borrowers into the model, and the results of modeling will explain why banks are keeping excess reserves. It is also obvious that the threshold of creditworthiness is raised during volatile periods, sometimes to the point that there are no creditworthy borrowers. It is impossible to make banks give away money without hope of getting it back by using fiscal or market means. Even by making them pay small interest on the reserves.
“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.”
To be clear here. It is NOT a closed loop. QE conducted on the OPEN MARKET (auction) through the trading desk of the NYFRB. Eligible to participate in auction are primary dealers and their clients.
“…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.”
The tradition that the FED started was to buy short term corporate paper, not treasuries. The tradition that the FED started, was also to set the FED interest rate regionally, as one size didn’t fit all.
To fund WW1, Wilson forced the FED to buy government debt. This ended the tradition that the FED began.
A very important oversight:
What MISH failed to mention that the Federal Reserve is PROTECTING the Banks’ profitability by “raising rates” so that it pay can “PAY MORE” for the “excess Reserves” held by banks which the Federal Reserve itself created by artificially created money that it had printed.
So Raising Rates is actually good for Banks. That is why Janet Yellen is so eager and banking stocks were rallying when she claimed to be raising rates since the “economy had improved”. In reality, it is just another give away to the banks.
In that vein, let me ask Americans and Brits this question:
What if everything you have ever known is a lie?
Let’s start with Winston Churchill.
Read more about Churchill here. I will expose more Truths in future comments.
http://ajitvadakayil.blogspot.com/2011/07/winston-churchill-henchman-or-hero-capt.html
Hello Mish-
Here’s another example of “Good Monetarism gone bad”. Remember, Bernanke’s Dinner Comment to about the Causes of the Depression to Friedman and Schwartz?: “You were right but we’ll never do it again…”. The FED’s moves can be De-Constructed along those lines – “We backed the money trucks up to the back of the banks just like you said…”. ‘N they did, using computers instead of messy ol’ trucks.
But a funny thing happened on the way to Monetarist Paradise: Monetarism was co-opted faster than a Liberal at a Marxist Barbeque. Friedman and Schwartz would have protested but, Alas!, it was too late. It was never about a Slow, Gradual Increase in $M1-$M2. The Run on the Banks that F&S worried about never materialized and would not have. The solution was re-focused to giving a few people access to “Early Money”.
J B Say must be cryin’ about now…
“Q: Why doesn’t the Fed just go back to the old way of doing things?
Coy: 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.”
Ok, so they can’t go back to the “old way” and just sell the securities. But there is nothing preventing the Fed from raising reserve requirements.
Is it possible that this is the case: During the housing bubble the banks securitized all manner of mortgages. The best mortgage backed securities were made up of primary mortgages, the worst were made up of second mortgages and home equity lines of credit. When homes went into foreclosure it was because of defaults on the primary mortgage – there was still some residual value in the home, which could be sold at a loss, with the loss being taken by the holder of the mortgage backed security. But, and this has always been left out of the equation, by definition if the primary mortgage is underwater, then the mortgage backed securities comprised of the second mortgages and HELOC’s are rendered totally worthless. My suspicion is that the Fed purchased all these worthless mortgage backed securities at face value from her member banks, making them whole, and then relabeled them as “excess reserves.” And that this is the real reason the Fed cannot sell them… they are worthless.
The FED’s number one job is to protect its member banks who own it. Paying interest on excess reserves is simply a way to provide funds to keep these owners alive. It is that simple.
The Fed is not “setting a floor” on interest rates by paying interest on excess reserves (IOER), and the rate paid has little to no effect on the rate banks are willing to lend to corporate or individual borrowers. With $2.3 trillion in excess reserves, the only thing limiting banks’ lending is their cost of funds, and finding an entity to lend to at a spread above cost of funds who will actually pay back the loan (and if the bankers can pretend they will be paid back many bank CEOs don’t even much care about a future default, as they will be long gone with their bonuses before the eventual recognition of loan default). The only banks borrowing in the Fed funds market borrow from entities which legally do not receive IOER on their Fed funds (e.g. the government sponsored entities or GSEs), and banks borrow Fed funds from them at a rate below the IOER rate and arbitrage the difference.
What does indirectly affect banks cost of funds is the Fed reverse repurchase (RRP) rate (currently 25 b.p.) paid largely to money market funds. This offering of RRPs actually soaks up Fed reserves (though less than $50 billion in the past few days auctions), and the government (t-bills rates), corporations (commercial paper rates), and banks (institutional deposit rates) must compete with what the Fed offers on this rate or all funds would flow to money market funds to get the RRP rate. Because the management fees on money market funds geared to individuals are in excess of the 25 b.p. RRP rate, the Fed’s RRP auctions are not a factor in where individuals hold their liquid funds yet, but if we saw a few more Fed rate increases that would change.
The $11.5 billion paid in IOER is nothing but a giant subsidy to the banking industry, which works out to ~$36 annually at the current 50 b.p. rate for every man, woman, and child in the United States ($11.5 billion/320 million citizens). And bear in mind this is in addition to the artificial gains earned by the banking industry as a result of the Fed lifting prices on treasury and mortgage markets with massive QE.
The Fed is not “setting a floor” on interest rates by paying interest on excess reserves (IOER), and the rate paid has little to no effect on the rate banks are willing to lend to corporate or individual borrowers. With $2.3 trillion in excess reserves, the only thing limiting banks’ lending is their cost of funds, and finding an entity to lend to at a spread above cost of funds who will actually pay back the loan (and if the bankers can pretend they will be paid back many bank CEOs don’t even much care about a future default, as they will be long gone with their bonuses before the eventual recognition of loan default). The only banks borrowing in the Fed funds market borrow from entities which legally do not receive IOER (e.g. the government sponsored entities or GSEs), and banks borrow Fed funds from them at a rate below the IOER rate and arbitrage the difference.
What does indirectly affect banks cost of funds is the Fed reverse repurchase (RRP) rate (currently 25 b.p.) paid largely to money market funds. This offering of RRPs actually soaks up Fed reserves (though less than $50 billion in the past few days auctions), and the government (t-bills rates), corporations (commercial paper rates), and banks (institutional deposit rates) must compete with what the Fed offers on this rate or all funds would flow to money market funds to get the RRP rate. Because the management fees on money market funds geared to individuals are in excess of the 25 b.p. RRP rate, the Fed’s RRP auctions are not a factor in where individuals hold their liquid funds yet, but if we saw a few more Fed rate increases that would change.
The $11.5 billion paid in IOER is nothing but a giant subsidy to the banking industry, which works out to ~$36 annually at the current 50 b.p. rate for every man, woman, and child in the United States ($11.5 billion/320 million citizens). And bear in mind this is in addition to the artificial gains earned by the banking industry as a result of the Fed lifting prices on treasury and mortgage markets with massive QE.
The Fed is not “setting a floor” on interest rates by paying interest on excess reserves (IOER), and the rate paid has little to no effect on the rate banks are willing to lend to corporate or individual borrowers. With $2.3 trillion in excess reserves, the only thing limiting banks’ lending is their cost of funds, and finding an entity to lend to at a spread above cost of funds who will actually pay back the loan (and if the bankers can pretend they will be paid back many bank CEOs don’t even much care about a future default, as they will be long gone with their bonuses before the eventual recognition of loan default). The only banks borrowing in the Fed funds market borrow from entities which legally do not receive IOER (e.g. the government sponsored entities or GSEs), and banks borrow Fed funds from them at a rate below the IOER rate and arbitrage the difference.
What does indirectly affect banks cost of funds is the Fed reverse repurchase (RRP) rate (currently 25 b.p.) paid largely to money market funds. This offering of RRPs actually soaks up Fed reserves (though less than $50 billion in the past few days auctions), and the government (t-bills rates), corporations (commercial paper rates), and banks (institutional deposit rates) must compete with what the Fed offers on this rate or all funds would flow to money market funds to get the RRP rate. Because the management fees on money market funds geared to individuals are in excess of the 25 b.p. RRP rate, the Fed’s RRP auctions are not a factor in where individuals hold their liquid funds yet, but if we saw a few more Fed rate increases that would change.
The $11.5 billion paid in IOER is nothing but a giant subsidy to the banking industry, which at the current 50 b.p. rate works out to ~$36 annually for every man, woman, and child in the United States ($11.5 billion/320 million citizens). And bear in mind this is in addition to the artificial gains earned by the banking industry as a result of the Fed lifting prices on treasury and mortgage markets with massive QE.
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