PrefBlog

OK, finance geeks, there’s a big treat for you today! I’ve had a little look at the Fed’s push to accellerate payment of interest on reserve balances:

The Fed got the authority to start paying interest in October 2011 under the Financial Services Regulatory Relief Act of 2006, signed into law on Oct. 13, 2006. The reason for the late implementation was budgetary. Paying interest on reserves will reduce the amount of income the Fed earns on its securities portfolio and remits to Treasury each year. Congress pushed back the date of implementation to minimize the near-term impact on the deficit.

The cost isn’t astronomical. The Congressional Budget Office estimated that the cost in the first year would be $253 million, rising to $308 million by the fifth year, for a total $1.4 billion over five years.
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The Fed has already raised the issue with Congress, although it hasn’t made a formal push. Getting Congress to agree to swallow the cost a few years early in principle shouldn’t be hard since Congress has already set aside its adherence to the principal of “Paygo” — that all revenue reductions and cost increases need to be offset elsewhere. The Fed could also further reduce the cost by arranging to pay interest only on excess reserves — the amount that exceeds the required minimum.

The idea of paying interest on reserve balances was mentioned briefly on PrefBlog in the post US Fed and Negative Non-Borrowed Reserves, which was largely a copy/paste from January 29, 2008. The former post has just been updated, by the way, with a note from the Fed confirming that negative non-borrowed reserves is a mathematical triviality.

As mentioned there, the Fed has advocated interest payments on reserves for a long time:

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed’s revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.

The Fed didn’t put a number on this additional expense but, as noted above, the Congressional Budget Office did … roughly $250-million to $300-million annually.

The Fed’s arguments in favour of the idea are two-fold, based on ideas of market efficiency and considerations of monetary policy implementation, as described by then-governor Laurence Meyer in 1998:

Reserve requirements are now 10 percent of all transaction deposits above a threshold level. Requirements may be satisfied either with vault cash or with balances held in accounts at Federal Reserve Banks. Depositories have naturally always attempted to reduce such non-interest-bearing balances to the minimum. For over two decades, some commercial banks have done so in part by sweeping the reservable transaction deposits of businesses into nonreservable instruments. These business sweeps not only avoid reserve requirements, but also allow firms to earn interest on instruments that are, effectively, equivalent to demand deposits.

In recent years, developments in computer technology have allowed depositories to begin sweeping consumer transaction deposits into nonreservable accounts. In consequence, the balances that depositories hold at Reserve Banks to meet reserve requirements have fallen to quite low levels. These consumer sweep programs are expected to spread further, threatening to lower required reserve balances to levels that may begin to impair the implementation of monetary policy. Should this occur, the Federal Reserve would need to adapt its monetary policy instruments, which could involve disruptions and costs to private parties as well as to the Federal Reserve. However, if interest were allowed to be paid on required reserve balances and on demand deposits, changes in the procedures used for implementing monetary policy might not be needed.
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The prohibition of interest on demand deposits distorts the pricing of transaction deposits and associated bank services. In order to compete for the liquid assets of businesses, banks set up complicated procedures to pay implicit interest on what are called compensating balance accounts.
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The payment of interest on required reserve balances could remove the incentives to engage in such reserve avoidance practices.

These arguments were largely repeated by then-governor Donald Kohn in 2004:

In conclusion, the Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.

One gets the feeling that the Fed, if required, could supply an entire bibliography of its attempts to obtain this authority! So could the Treasury!

They finally got their wish in 2006:

Law Passed to Pay Interest on Reserves, Effective in 2011
The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve banks to pay interest on reserve balances and gave the Board of Governors authority to lower reserve requirements on all transaction deposits (applied to deposits above a certain threshold level) to as low as zero percent, from their previous minimum top marginal requirement ratio of eight percent. These changes are not effective until October 2011.

I must confess failure in attempting to determing whether Fed Funds Loans are currently themselves reservable. The Reserve Maintenance Manual doesn’t cite these transactions explicitly. Sorry!

Now, there is some concern that this move will reduce interbank lending:

Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

… and, of course, we can always rely on Naked Capitalism to highlight scary bits.

One of the objectives in paying interest on reserve balances is, in fact, to ensure that reserve balances are still held, as explained by Governor Kohn in 2003:

However, if interest rates were to return to higher levels, sweep activity could intensify again and potentially become a concern. To prevent the sum of required reserve and contractual clearing balances from dropping even lower and to diminish the incentives for depositories to engage in wasteful reserve-avoidance activities, the Federal Reserve has long sought authorization to pay interest on required reserve balances and to pay explicit interest on contractual clearing balances. H.R. 758 would provide such authorization. With interest paid on required reserve balances, some sweep programs would likely be unwound, and new programs would be less likely to be implemented, thereby helping to boost the level of such balances. Eliminating such wasteful reserve-avoidance activities would also tend to improve the efficiency of the financial sector.

Payment of explicit interest on contractual clearing balances could result in an increase in the level of these balances; some depositories are currently constrained in the amount of such balances that can earn usable credits because of their limited use of Federal Reserve services. Moreover, payment of explicit interest would help to maintain the level of clearing balances at a time of rising interest rates. At present, some depositories pay for all their Federal Reserve services with credits earned on clearing balances; these institutions would not be able to use their additional credits if interest rates were to rise. If enough institutions were in this position, contractual clearing balances might drop below levels needed to be helpful for the implementation of monetary policy. With explicit interest, the level of balances on which interest could be effectively earned would not be limited to the level of charges incurred for the use of Federal Reserve services. Therefore, these depositories would not be impelled to reduce their balances when interest rates rise.

In other words, the Fed wants to be able to influence the market via the Fed Funds rate (as well as through reserve requirements, the discount rate and the hoped-for rate paid on reserves), but it won’t be able to do so if there is no Fed Funds market. In addition to the projected business efficiencies to be gained by allowing interest to be paid on demand deposits, the Fed hopes, by paying interest on the balances, to encourage participants to participate in the market in the first place.

There has been an interesting dust-up in the normally sedate world of analyst reports on Canadian banking … Citibank says Royal Bank of Canada might have billions in credit losses this quarter and Royal Bank says that’s horse-patootie. The analyst report is here (hat tip:Yahoo Message Boards). Citibank, by the way, is raising yet another $3-billion equity.

Via Bloomberg comes news that Markit is establishing a Municipal CDS Index. Whether or not contracts on this index will have a delivery option is unclear – I sure hope it does! Markit, by the way, is engaging in a live test of their disaster recovery plan:

Due to a flood in the London Bridge area which has caused an evacuation of the entire More London business district, Markit Group London is currently operating from its Disaster Recovery (DR) site. We appreciate your support whilst we strive to maintain full delivery of our products and services.

… good luck to them!

The Royal Bank new issue closed successfully, but had little impact on the overall market, in which volumes were normal and significant price changes rare.

There were seventeen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Tuesday, April 29th, 2008 at 8:14 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.