Federal Reserve has bad idea on interest rates for different banks

There is a problem with the Federal Reserve system for managing interest rates. It is attracting new bank entrants, but the Federal Reserve does not want their business. To “fix” the problem, it has proposed rule changes that govern the way it pays banks interest on reserves. The plan would allow it to pay different banks different rates on reserves, including a rate of 0 percent. The Federal Reserve would choose which banks qualify for a high rate, which quality for a low rate, and which will earn nothing.

These changes would give the Federal Reserve a new dangerous power to use interest on reserves to choose winners and losers, including blocking new bank entrants it deems “problematic.” In 2006, when Congress gave the Federal Reserve authority to pay banks interest on reserves, it never imagined the Federal Reserve would use that authority to pay favored banks higher interest rates on their reserves. Congress needs to revisit the Financial Services Regulatory Relief Act to limit central bank authority and require the Federal Reserve to treat all legally chartered banks equally.

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New startups have satisfied the existing rules and regulations and successfully acquired bank charters that entitle them to open Federal Reserve master accounts and earn interest on reserves. These startups have secured state charters to operate a limited purpose bank that takes in large deposits from money market mutual funds and similar institutions, invests these deposits in a Federal Reserve master account, and earn interest at the “interest on excess reserves” rate. These limited purpose banks have low operating costs so they can keep a small spread and pass most of the reserve interest onto mutual fund shareholders.

Banks, of course, would prefer that these institutions not get access to Federal Reserve master accounts. Banks currently earn a handsome spread taking in customer deposits and placing them at the Federal Reserve, which currently pays banks 2.4 percent on reserve balances while banks pay on average 10 basis points to 18 basis points to acquire insured deposits, depending on the type of account. If the new limited purpose banks are successful, deposits will leave banks and flow into money market funds that pass the reserve interest on to their customers. To staunch deposit outflows, banks will be forced to increase the rates they pay depositors. The cost of funds will increase and a larger share of reserve interest payments will be passed on to savers who will earn higher returns on their bank deposits and money market mutual funds.

You and I might think that allowing these startups access to open reserve accounts at the Federal Reserve is a good idea, but its proposal is clearly designed to block these new entrants. In its advanced notice of proposed rulemaking, the central bank argues that giving these startups master accounts could make it more difficult for the Federal Reserve to conduct monetary policy and might even create new financial instabilities.

The argument that these startups will disrupt its process for controlling interest rates by ruining liquidity in the federal funds and repo markets is not well founded. The Federal Reserve itself impaired the liquidity in these markets when it started paying banks interest on excess reserves. Today, the Federal Reserve sets interest rates by fixing the reserve rate. The federal funds rate is no longer a signal of the true supply and demand conditions in the domestic banking system. Domestic banks rarely lend significant amounts of federal funds because lending is risky and holding reserves at the central bank is not only riskless, it pays a higher rate.

The argument that these new institutions create systemic risk is likewise dubious. These institutions do not require deposit insurance because their only investment is holding reserves in a central bank account. Presuming they operate legally and follow their limited purpose charters, they are super safe without deposit insurance. But the Federal Reserve declares that, should something lead depositors to question the safety of the regulated banking system, depositors might run banks and move their savings to these new institutions. It is ironic that the Federal Reserve wants to keep savers from earning higher rates in order to prevent bank runs the next time regulators fail to forsee a brewing financial crisis.

Expanding the power of its board to allow the Federal Reserve to choose which banks it will reward by paying a high interest rate on reserves and which it will punish by paying a low or zero interest rate is a bad idea. Congress never anticipated that the Federal Reserve would interpret its authority to pay interest on bank reserves as the authority to pick which banks to reward and which to punish. Congress must step in and stop the Federal Reserve from exercising powers that it was never granted.

Paul Kupiec is a resident scholar at the American Enterprise Institute.