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.
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.
Of all the sciences, economics is the most exact, not mathematics, optics, astronomy, and physics. “The exact sciences are characterized by accurate quantitative expression, precise predictions and/or rigorous methods of testing hypotheses involving quantifiable predictions and measurements.” The money stock (& DFI credit, where: loans + investments = deposits), can never be managed by any attempt to control the cost of credit [or thru a series of temporary stair stepping or cascading pegging of policy rates on “eligible collateral”; or thru “spreads”, “floors”, “ceilings”, “corridors”, “brackets”, IOeR, etc.]. Using a price mechanism (interest rates as a monetary transmission mechanism), to ration Fed credit is non-sense. The effect of current open market operations on interest rates (now via the remuneration rate), is indirect, varies widely over time, and in magnitude. . What the net expansion of money will be, as a consequence of a given change in policy rates, nobody knows until long after the fact. The consequence is a delayed, remote, & approximate control over the lending and money-creating capacity of the banking system. Economists should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about. Keynes’ liquidity preference curve (demand for money) is a false doctrine. The only tool at the disposal of the monetary authorities, in a free capitalistic society, through which the volume of money can be controlled is legal reserves (not interest rate manipulation). And legal reserves ceased to be binding c. 1995 – at the start of the housing boom/bust. By using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve became the real-estate bubble’s engine. The “administered” or actual prices would not be the “asked” prices, were they not “validated” by money flows, i.e., “validated” by the world’s Central Banks. The first rule of reserves and reserve ratios under monetarist guidelines should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. Monetary policy should limit all reserves to balances in the Federal Reserve banks (IBDDs), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size (something Nobel Laureate Dr. Milton Friedman also advocated, December 16, 1959). Interest is the price of loan-funds (the market’s bailiwick). The price of money is the reciprocal of the price-level (the Fed’s bailiwick). See: Dr. Daniel L. Thornton, Vice President and Economic Adviser: Research Division, Federal Reserve Bank of St. Louis, Working Paper Series, “Monetary Policy: Why Money Matters and Interest Rates Don’t” http://bit.ly/1OJ9jhU
Former Chairman Alan Greenspan: “One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing.” Simply false. See: “New Measures Used to Gauge Money supply” – WSJ 6/28/83 “The experimental measures are designed to resolve some of the confusion by isolating money intended for spending, the money held as savings. The distinction is important because only money that is spent-so-called “true money” – influences prices and inflation.” And we knew this already: In 1931 a commission was established on Member Bank Reserve Requirements. The commission completed their recommendations after a 7 year inquiry on Feb. 5, 1938. The study was entitled “Member Bank Reserve Requirements — Analysis of Committee Proposal” It’s 2nd proposal: “Requirements against debits to deposits” http://bit.ly/1A9bYH1 After a 45 year hiatus, this research paper was “declassified” on March 23, 1983. By the time this paper was “declassified”, Nobel Laureate Dr. Milton Friedman had declared RRs to be a “tax” [sic]. See my blog post “Surrogates”: The “unified theory” is: (1) that the non-banks are the customers of the commercial banks. Thus (2) all demand drafts originating from the NBs clear thru the CBs. (3) Bank reserves are driven by payments (bank debits). And (4) legal reserves are based on transaction type deposit classifications 30 days prior. The sine qua non of monetary management is total current control by a central monetary authority over the volume of legal reserves held by all money creating institutions, and over the reserve ratios applicable to their deposits. Prima facie evidence that the Reserve banks and the commercial banks have created credit, as with all bank credit creation, is an expansion in the money stock. Prima facie evidence that the money stock, transaction based accounts, has expanded, is given by the roc in legal, RRs – the definitive adjusted monetary base. See: Phillip George: “we can state categorically that both the Friedmanian and the Austrian definitions of money are incorrect because they both include savings deposits” and “To measure money accurately, we also need to measure the amount of savings contained in M1, and subtract the savings from M1.” http://bit.ly/2u3xiBV See: Monetary Flows (rates-of-change, Δ, in commercial bank debits to transaction deposit classifications): http://bit.ly/2sW5vGi
Jack: Thank you for your comment. In the pre-crisis regime, the Fed adjusted the supply of reserve balances so as to keep the federal funds rate around the target established by the FOMC. These adjustments were made almost daily through open market operations. One example of an open market operation is a repo transaction that adds reserves. Under a repo, the Fed buys a security under an agreement to resell that security in the future. During the term of the repo in this example, reserves increase. With these open market operations the Fed would set the supply of reserves so that it would intercept the demand for reserves at the desired rate. A more detailed description of OMOs can be found here: https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm. There are also a number of publications describing how OMOs can be used in monetary policy implementation: for example, “Understanding Monetary Policy Implementation,” at https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_quarterly/2008/summer/pdf/ennis.pdf
meisonas: Thank you for your comment. Banks are not required to hold vault cash. Typically, when banks hold vault cash, they do so to satisfy the needs of their customers. Banks can also use this vault cash to satisfy their reserve requirements. For more information on aggregate vault cash used to satisfy reserve requirements, you can look at the statistical release, Aggregate Reserves of Depository Institutions and the Monetary Base (H.3), at https://www.federalreserve.gov/releases/h3/.
Engin: Thank you for these interesting questions. First of all, as your question points out, the FOMC sets a target for the federal funds rate. It is important to note that the federal funds rate is targeted, rather than set, because it is a market rate, rather than an administered rate. The Federal Reserve can influence market rates, including the federal funds rate, with the use of various tools of monetary policy, but a market rate cannot be directly controlled. The interest rate paid on excess reserves (IOER) gives the Federal Reserve an important tool to target the federal funds rate. By raising and lowering this rate, the Federal Reserve can change the attractiveness of holding balances and thus influence the rate at which institutions are willing to trade in the market. IOER pulls money market rates up by giving incentives for borrowers to compete among themselves to attract reserves, which earn IOER. In the current environment, lenders of funds in this market are generally those that do not have access to IOER, and thus are willing to lend below IOER. Another set of Liberty Street blogs discusses borrowers and lenders in the fed funds market. http://libertystreeteconomics.newyorkfed.org/2013/12/whos-lending-in-the-fed-funds-market.html For information on income, expenses, and distribution of net earnings of the Federal Reserve Banks, the annual report is a good source, with a table on page 108 detailing forms of interest expense, including interest paid on depository institution deposits. For additional context, it may also be useful to look at Federal Reserve remittances to the U.S. Treasury (which are the residual net earnings that Federal Reserve sends to the U.S. Treasury after interest and other expenses). An overview of these remittances is provided starting on page 18 of the report. https://www.federalreserve.gov/publications/files/2016-annual-report.pdf. Interest income on the Federal Reserves’ assets has continued to support substantial remittances to Treasury. A historical depiction of remittances can be found here: https://www.federalreserve.gov/newsevents/pressreleases/other20170110a.htm Congress amended the Federal Reserve Act to provide that Reserve Banks may pay interest on balances (Federal Reserve Act, Section 19(b)(12), found at https://www.federalreserve.gov/aboutthefed/section19.htm). There is no end date for this authority. The regulations implementing the authority are found in Section 204.10 of Regulation D (https://www.ecfr.gov/cgi-bin/text-idx?SID=72acbbcb5b12782a5e7a94cc4e1ecb65&mc=true&node=se12.2.204_110&rgn=div8), which, among other things, includes specification of the rates. An overview of the regulatory and legal history relating to interest on reserves can be found here: https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
In the explanation of reserves the following is stated: “Banks satisfy these requirements by holding cash in their vaults and, if that cash is insufficient, by keeping reserve balances at the Fed.” By vault cash does this mean physical cash is still stored for this purpose or has this now been digitised? I would imagine that requiring physical cash would impede the grow of internet-based banks that have a small physical presence.
Thank for your good post. I also studied the paper of Joshua Feinman. I am an economic student so I have some questions. I would be grateful if you could possibly guide me. You wrote: “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”. 1. How did Fed provide the supply of reserves? By adjusting required reserve rate? 2. How did This “scarcity” of reserves help to achieving the target for the level of the FOMC’s policy rate, the federal funds rate?
K K: Thank you for your comment. The idea behind the Friedman rule is that there should be no opportunity cost of holding money. That is, the return on money should be approximately the same as the return of close substitutes, like Treasury bills. This should be true for any level of the interest rate, even negative rates. When setting the stance of monetary policy, by choosing a level of the policy rate, a central bank hopes to influence both short-term interest rates, which applies to assets that can be close substitutes for money, and longer-term rates, such as mortgage rates. The idea is to set the policy rate to influence interest rates and financial conditions to help achieve the central bank’s mandated goals over time; in the case of the Fed, those goals are maximum employment and price stability. If interest rates are too low for too long a period, then there is a greater risk of inflation rising too high. Conversely, if interest rates are too high for too long, then there is a greater risk that economic growth will be inappropriately constrained. Central banks set the level of the policy rate based on their assessments of economic conditions and the economic outlook. The idea behind setting a negative policy rate is that the economy is sufficiently weak such that even if the policy rate was zero, overall interest rates are not low enough to help stimulate the economy as much as is needed.
If there should be no opportunity cost for holding money as Friedman states, how do negative interest rates make any sense as a policy tool. Wouldn’t that lead to wasteful behavior with no policy benefits.
Dear Martin and Authors Questions, 1- Why does FED select this level of interest rate same as Federal Funds Target Range Upper Limit ? Why doesn’t FED select this level of interest rate same as Federal Funds Target Range Lower Limit ? 2- How can I see cost of this policy from FED Balance Sheet ? From 2008, how much dolar is spent for this policy ? 3- When does FED Authority finish to pay interest to reserves ? Sincerely Engin YILMAZ