Why Pay Interest on Required Reserve Balances?

Laura Lipscomb, Antoine Martin, and Heather Wiggins

The Federal Reserve has paid interest on reserves held by banks in their Fed accounts since 2008. Why should it do so? Here, we describe some benefits of paying interest on required reserve balances. Since forcing banks to hold unremunerated reserves would be akin to levying a tax on them, paying interest on these balances is a way to eliminate or greatly reduce that tax and its negative effects.

What Are Reserves?

Reserves are balances held by depository institutions (hereafter, banks) in accounts at their regional Federal Reserve Bank, which are comparable to checking accounts at a commercial bank. The Federal Reserve Act provides the authority for the Fed to set reserve requirements on banks. Reserve requirements are an amount equal to a given fraction of a bank’s net transaction accounts. Banks satisfy these requirements by holding cash in their vaults and, if that cash is insufficient, by keeping reserve balances at the Fed. This amount—reserve requirements minus vault cash—is a bank’s reserve balance requirement. Banks must satisfy their reserve balance requirements regardless of whether these reserves are remunerated.

Why Should Banks Be Forced to Hold Reserves?

Before the Fed could pay interest on reserves, it provided a supply of reserves that was close to the total level of banks’ demand. This “scarcity” of reserves was important to achieving the target for the level of the FOMC’s policy rate, the federal funds rate. Reserve balance requirements provided a stable and predictable level of bank demand for the Fed to target. The Federal Reserve Act specifies that the Fed can administer reserve requirements to create this demand to facilitate monetary policy implementation (a Federal Reserve Bulletin article by Joshua Feinman details the current purpose of reserve requirements as well as their historical uses).

Since the financial crisis, the supply of reserves has increased sharply as a result of the Fed’s lending facilities and asset purchase programs; consequently, the Fed can no longer rely on reserve scarcity to target rates. Instead, amidst an abundance of reserve supply relative to demand, the Fed is using interest on excess reserves as its primary tool to successfully target the federal funds rate. The overnight reverse repurchase agreement facility is also used, as a supplementary tool.

Aside from meeting their reserve requirements, banks use reserves to settle payments, either from customer traffic or as a result of proprietary transactions. Interbank payments are necessary to allow consumers to purchase the goods they want, even if they don’t use the same bank as the seller, or for workers to receive their wages, even if they don’t use the same bank as their employers. Some banks may choose to hold more reserves than required in order to accommodate their settlement needs.

The “Reserve Tax”

If reserves are not remunerated, then forcing a bank to fulfill reserve requirements is similar to imposing a kind of “reserve tax.” Banks would be willing to hold a certain amount of reserves for self-interested reasons. Beyond that level, banks will take action to avoid the tax, unsurprisingly. This would be particularly true as nominal interest rates increase, pushing up the opportunity cost of holding unremunerated reserves. Fed Governors Laurence Meyer and Donald Kohn discussed this incentive in testimony before Congress in the years leading up to the Fed receiving the authority to pay interest on reserves (1998, 2000, 2001, 2003, 2004, and 2006).

Trying to avoid the reserve tax makes sense for banks, but it can be costly for society as a whole. Two examples illustrate why. One way banks avoid the reserve tax is by using “sweep accounts” to reduce reserve requirements. Sweep accounts are essentially an accounting technique that allows a bank to move funds out of an account against which it would be required to maintain reserves, such as a checking account, and into an account that is not subject to reserve requirements, such as a savings account. Avoiding the reserve tax through the use of sweep accounts results in a transfer of resources from the public sector, which suffers lower tax revenues, to banks, which gain an equal amount in reduced taxes. In that sense, the effect of the sweep account is neutral from the perspective of society as a whole. However, banks incur a cost to create and maintain these accounts and that cost is wasted from the perspective of society, since these resources could have been used for a socially useful purpose, such as generating new loans.

Another way banks avoid the reserve tax is by engaging in trades to ensure that they hold just enough reserves to fulfill their requirements and serve their own interests, but no more. In the regular course of business, banks make and receive payments that move their reserve positions away from their ideal, minimum amount. Banks that receive more reserves than they pay out will want to lend reserves. Similarly, banks that make more payments than they receive will want to borrow reserves. While shuffling reserves in that way has value for banks, because it reduces their costs, it serves little or no social purpose because the reserves must ultimately be held by a bank. So the resources devoted to these interbank trades are wasted from society’s point of view.

In his book The Optimum Quantity of Money, Milton Friedman argued that there should be no opportunity cost of holding money, a proposal now known as the “Friedman rule.” Friedman was concerned that if holding money is costly, wasteful behavior similar to that described in this post would arise.

Eliminating the Reserve Tax

Congress gave the Fed the authority to pay interest on reserves balances in 2006, with an effective date of October 2011. The effective date was advanced to October 2008 with that month’s passage of the Emergency Economic Stabilization Act and the Fed began using the authority shortly thereafter. The Fed pays interest on required reserve balances to eliminate costly distortions and ensure that banks don’t spend resources avoiding the reserve tax, allowing them to focus more on their core business of making loans.

The payment of interest on required reserve balances may eliminate the opportunity cost of holding unremunerated reserve balances, but it may not reimburse banks for all costs associated with holding required balances. For example, banks subject to the liquidity coverage ratio, which ensures that institutions have enough high-quality liquid assets to cover their projected near-term outflows, may incur additional costs by holding required balances. While banks can hold excess reserves as high-quality liquid assets, required reserve balances are excluded from this measure. As a result, we can think of required balances as needing to be funded with longer-term liabilities that are not included in the projected outflows.

The net cost of holding required balances can then be estimated as the difference between funding required balances with short-term liabilities versus doing so with longer-term liabilities. In addition to funding with longer-term liabilities, we could also estimate the cost of capital associated with holding these assets, raising our cost estimates further. Such calculations suggest that the net cost of holding required balances for banks subject to the liquidity coverage ratio may range from about half a basis point to a few basis points in terms of these banks’ return on assets. (For comparison, banks in the United States have returns on assets of around 100 basis points in the current environment.) These costs may help determine whether banks continue to operate sweep programs to reduce required reserve balances, despite the payment of interest on such balances.

In our next post, we will turn our attention to the payment of interest on excess reserve balances and discuss some of the benefits to the financial system of operating in a reserve-abundant regime.

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.

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 Federal Reserve Bank of New York’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 Required Reserve Balances?” Federal Reserve Bank of New York Liberty Street Economics (blog), September 25, 2017, http://libertystreeteconomics.newyorkfed.org/2017/09/why-pay-interest-on-required-reserve-balances.html.