American taxpayers, not banks, deserve Fed interest payments
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Monetary policy has the Federal Reserve on a collision course the American taxpayer. Not only does the Fed pay banks to keep them from lending to businesses and consumers, the Fed’s interest on reserves policy has taxpayers subsidizing large domestic and foreign banks. A simple fix will shift interest on reserves payments from banks to taxpayers and simultaneously enhance the Fed’s ability to control interest rates. The solution is for Congress to create new mutual fund that earns Fed interest on reserves payments.

As the Fed tightens monetary policy, the current interest on reserves rate of 1.25 percent will increase. Higher interest on reserves rates will increase the Fed’s interest expense and the federal budget deficit. In 2016, the Fed paid $12 billion in interest on reserves. In August, banks held $2.34 trillion in reserves. If the rate is unchanged, banks will earn more than $29 billion annually on these balances. About half of interest on reserves payments go to the largest U.S. banks and a third go to foreign banks. Only a tiny share of interest on reserves is passed through to U.S. business and consumers in the form of higher bank deposit rates.

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Today, the federal funds rate trades in a range between two rates set by the Fed: the interest on reserves rate and the rate the Fed pays on reverse repurchase agreements. These are the rates the Fed pays to borrow banks’s and other intermediaries’s reserves. The Fed has no direct investment use for these reserves. When banks lend reserves to the Fed, they cannot lend them to consumers and businesses. Because of the massive surplus of reserves created by its crisis-fighting policies, the Fed must now use interest on reserves and reverse repurchase agreements to set the federal funds rate and control bank lending growth.

 

In theory, as long as banks can raise deposits and other funds more cheaply than the interest on reserves rate, they should raise cash and investment in reserves. Interest on reserves arbitrage is, in theory, how the interest on reserves influences short-term rates outside of the federal funds market. But in reality, interest on reserves arbitrage does not allow the Fed to control the federal funds rate, let alone other short-term rates. Some nonbank institutions can keep reserves at the Fed, but only banks earn the interest on reserves.

Institutions that don’t earn interest but have reserve balances are willing to lend them out, and in theory, banks should want to borrow these reserves to earn the interest on reserves. But various frictions including some related to bank regulations and deposit insurance keep banks from bidding up the rate on reserves that earn no interest. Using the interest on reserves alone, the federal funds market for nonbank reserves trades significantly below the interest on reserves rate.

The Fed created reverse repurchase agreements to fix the interest on reserves arbitrage problem. In an reverse repurchase agreement, the Fed borrows the reserves of qualified nonbanks and pledges Treasury securities as collateral. The Fed agrees to buy back the securities either the next day, or at the end of a fixed term. This complex process is required under current law because the Fed is only authorized to pay interest on reserves to depository institutions. The Fed sets the reverse repurchase agreement rate below the interest on reserves rate to place a “floor” on the federal funds rate.

A select number of institutions are allowed to make reverse repurchase agreement bids, and the Fed limits an institution’s participation to $30 billion. The total volume of reverse repurchase agreements is a Fed policy parameter. In July, outstanding reverse repurchase agreements totaled $360 billion. Interest on reserves and reverse repurchase agreement policies are only indirectly linked to rates consumers and businesses receive or pay for overnight deposits or credit. In particular, the rates that banks pay on deposits have not tracked the Fed’s federal funds rate target.

The most recent data indicate that the national average rate banks pay for interest checking and savings deposits are 4 basis points and 6 basis points, respectively, while banks earn 1.25 percent. There is no public data on the Fed’s reverse repurchase agreement rate offers, but nonbank institutions, primarily money market mutual funds, have passed through a larger share of recent Fed rate hikes. Taxpayers are the ones paying financial institutions billions of dollars to lend their reserves to the Fed. But these institutions, especially banks, are passing very little of these interest payments back to taxpayers in the form of higher deposit rates. The Fed defends this practice by arguing that bank rates are historically just slow to adjust. Slow indeed. Banks have been earning interest on reserves for nearly 10 years.

There is an easy fix for this politically-charged issue. Congress can create a new class of mutual fund that only invests in Fed reserve balances and permit the Fed to pay these funds interest on reserves. This would eliminate unnecessary transactions costs generated by reverse repurchase agreements. These new mutual funds should be permitted to deposit funds directly with the Fed without limit. Since these funds are risk free, they should be exempt from most money market fund regulations. Congress should limit the number of customer transactions permitted per month and consider withdrawal restrictions so these new funds are not substitutes for transactions accounts.

The Fed can set the rate it pays on mutual fund reserve balances, and the mutual funds can pass the rate on to businesses and consumers after deducting a minimal management fee. These new accounts will provide business and consumer with a low cost way to benefit from the interest payments now needed to manage monetary policy. They will also create the competition needed to get banks to pass through a much larger share of their interest on reserves earnings to depositors. Moreover, since the largest banks earn the lion’s share of interest on reserves interest, this innovation will reduce the too-big-to-fail taxpayer subsidies that the largest banks currently enjoy.

Paul Kupiec is a resident scholar at the American Enterprise Institute, where he studies systemic risk and banking regulation. He previously served as director of the Center for Financial Research at the Federal Deposit Insurance Corporation and chairman of the Research Task Force of the Basel Committee on Banking Supervision.


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