The public’s interest

Is the Federal Reserve giving banks a $12bn subsidy?

Or is the interest the Fed pays them a vital monetary tool that benefits the taxpayer?


EVERY time the Federal Reserve has raised rates since the financial crisis, as it did on March 15th, it has done so in part by increasing “Interest On Excess Reserves” (IOER). This obscure policy rate is surprisingly controversial. Jeb Hensarling, the Republican chair of the congressional committee that oversees the Fed, has called it a “subsidy” to some of the largest banks in America.
 
To understand the argument, consider the Fed’s year-end financial statement. In 2016 it earned $111.1bn in interest income on its vast portfolio of securities. But it also paid JPMorgan Chase, Wells Fargo, and other mostly big banks $12bn in interest on excess cash deposited at regional Federal Reserve banks. Such IOER payments are both woefully unpopular and critical to the Fed’s monetary policy.
Over a decade ago, to give the Fed better control of short-term interest rates, Congress authorised it to pay interest on funds in excess of those banks need to meet reserve requirements. The policy was first used during the financial crisis in 2008. But today, IOER is the Fed’s primary monetary-policy tool, essential to its setting of the Federal Funds rate.

IOER has drawn fierce flak from Congress. If banks can park their money at the Fed, they seem to have less incentive to lend to firms and consumers. About half of all excess reserves are held by America’s 25 largest banks, with a third, to Congress’s horror, held by foreign banks. The two groups earn roughly 85% of the Fed’s interest payment.
 
Many analysts argue that these interest payments—amounting to less than 2% of the banks’ total income—are in fact trivial. They claim banks would rather earn higher returns elsewhere, and that the real winner from the current arrangement is the government. The excess reserves help finance the Fed’s $4.5trn balance-sheet, which generated almost eight times more income for the Treasury in 2016 than was paid out in interest.

This debate is likely to intensify. American banks hold over $2.1trn in excess reserves. As rates rise, the cost of paying interest on them will climb—to $27bn this year, according to Fed projections and $50bn by 2019 (see chart). That may be too much. Mark Calabria of the Cato Institute, a think-tank, says that anything that can be tagged as “paying banks $50bn a year not to lend” will be “politically unsustainable”.

Meddling with the arrangement might cost even more. Without IOER, banks would try to lend their excess reserves to each other, so short-term interest rates would collapse. To keep control of monetary policy—and avert a surge in inflation—the Fed would have to sell assets rapidly to withdraw reserves from the system. The disruption, a recent analysis concluded, could prove “extremely costly to taxpayers”.

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