Why Pay Interest on Excess Reserve Balances?

Laura Lipscomb, Antoine Martin, and Heather Wiggins

In a previous post, we described some reasons why it is beneficial to pay interest on required reserve balances. Here we turn to arguments in favor of paying interest on excess reserve balances. Former Federal Reserve Chairman Ben Bernanke and former Vice Chairman Donald Kohn recently discussed many potential benefits of paying interest on excess reserve balances and some common misunderstandings, including that paying interest on reserves restricts bank lending and provides a subsidy to banks. In this post, we focus primarily on benefits related to the efficiency of the payment system and the reduction in the need for the provision of credit by the Fed when operating in a framework of abundant reserves.

Excess Reserve Balances and the Implementation of Monetary Policy

Excess reserve balances are reserves held by banks above their reserve balance requirements. Banks aren’t required to hold excess reserve balances and they can adjust the level of their holdings by borrowing or lending reserves. However, the aggregate amount of reserves in the banking system is controlled by the Fed, as explained in this article.

Before the Fed could pay interest on reserves, keeping excess reserves scarce was essential to implement monetary policy. Since reserves did not earn interest, they had to be scarce, relative to banks’ demand, to have value. To adjust the value of reserves to target the federal funds rate—the unsecured rate at which banks borrow reserves overnight in the federal funds market (and the policy rate of the Federal Open Market Committee (FOMC)), the Fed would increase or decrease the supply of reserves in small amounts. All else equal, a small increase in the amount of reserves supplied lowered the effective federal funds rate. Likewise, a small decrease in reserve supply raised the effective federal funds rate.

The old operating framework was not without its costs. As explained in a recent speech by Lorie Logan, a senior vice president in the New York Fed’s Markets Group heading Market Operations Monitoring and Analysis, quantity-based monetary policy implementation is resource-intensive, requiring staff at the New York Fed and the Fed Board of Governors to forecast reserve demand and supply, and to conduct frequent open market operations. The minutes from the November 2016 FOMC meeting also note the need for frequent open market operations in this type of framework.

The authority to pay interest on reserve balances provided the Fed an important tool for implementing monetary policy. Instead of relying on small adjustments to the quantity of reserves to target a level of market rates, the Fed can steer market rates by adjusting the return banks earn on the balances held overnight in their Fed accounts. That is, by raising or lowering the rate paid on excess reserves, the Fed can alter the value banks place on reserves and influence rates in the federal funds market. Since the Fed can implement monetary policy through a rate-based rather than a quantity-based mechanism, it has the flexibility to provide a greater supply of reserves while still controlling short-term interest rates.

Some Benefits of a Large Reserve Supply

Conducting monetary policy with a relatively abundant supply of reserves has multiple benefits: First, it makes the U.S. payment system more efficient and, second, it reduces the reliance of the financial system on intraday and overnight credit from the Fed. We discuss each effect in turn.

In an Economic Policy Review article (summarized on Liberty Street Economics), Morten Bech, Antoine Martin, and James McAndrews show that interbank payments occur earlier in the day when the supply of reserves increases. This finding is evidence that banks are more willing to relinquish reserves early and are therefore engaging in less economizing and hoarding of reserves, making the payment system more efficient. When reserves are scarce, banks are more reliant on the reserves they receive from other banks to make their own payments than when reserves are more abundant. So reserve scarcity exposes the payment system to a greater risk that a disruption at one bank could spill over and affect the system as a whole. Also, having a larger share of payments settled early reduces the potential consequences of a late day operational disruption. McAndrews and Alexander Kroeger recently updated the earlier study and found that the benefits persist even with a very high level of reserves.

In another Liberty Street Economics post, Rodney Garratt, McAndrews, and Martin show that the amount of intraday credit the Fed needs to extend to banks to cover daylight overdrafts (a negative balance in a bank’s Fed account at any point in the day) is much lower when the supply of reserves is high. The Fed provides intraday credit to healthy banks through collateralized, daylight overdrafts. The collateral a borrowing bank posts protects the Fed from the credit exposure. A large supply of reserves gives banks a sizable buffer to make payments throughout the day without needing to wait for the receipt of other payments or relying on daylight credit from the Fed or other counterparties. This reduces reliance on the Fed without affecting the availability of settlement liquidity. In fact, the ability of banks to make payments without incurring an overdraft may contribute to the earlier settlement of payments mentioned above.

In addition to needing less daylight credit, banks require less overnight credit in the form of discount window loans when reserves are abundant. The relatively abundant reserve environment means that fewer banks are caught short of balances at the end of the day, or at the end of a reserve maintenance period, which can lead to a scramble for funds, a spike in the federal funds rate, and banks occasionally accessing the discount window. Nevertheless, preparations to borrow at the discount window remain an important part of banks’ contingent liquidity preparations. Banks have posted about $1.5 trillion in collateral to the Fed so that they are ready to borrow should they need a backup source of funding. The lendable value of collateral pledged by all depository institutions is published in the footnotes of Table 5 of the Quarterly Report of Federal Reserve Balance Sheet Developments.

Summary

The authority to pay interest on reserves is an important tool that most central banks around the world possess. Before the financial crisis, the Fed’s monetary policy implementation framework relied on reserve requirements and frequent Fed interventions in the market to manage a scarce reserve supply. Paying interest on required reserve balances was sought to reduce banks’ incentives to engage in wasteful avoidance behavior, as described in our previous post. The current framework of abundant reserve supply fosters greater settlement liquidity while at the same time reducing banks’ reliance on the Fed for intraday and overnight credit provision. Despite the current high level of liquidity, the large amount of collateral posted to the Fed suggests that banks recognize the importance of the discount window as a means to access liquidity in unexpected circumstances.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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Laura Lipscomb is assistant director and chief in the Federal Reserve Board of Governors’ Division of Monetary Affairs, heading the monetary policy operations and analysis section.

Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

Heather Wiggins is a senior financial analyst in the Federal Reserve Board of Governors’ Division of Monetary Affairs.

How to cite this blog post:

Laura Lipscomb, Antoine Martin, and Heather Wiggins, “Why Pay Interest on Excess Reserve Balances?,” Federal Reserve Bank of New York Liberty Street Economics (blog), September 27, 2017, http://libertystreeteconomics.newyorkfed.org/2017/09/why-pay-interest-on-excess-reserve-balances.html.