FOREIGN BANKS BID FAREWELL TO FED´S FREE MONEY TREE / THE WALL STREET JOURNAL

Foreign Banks Bid Farewell to Fed’s Free Money Tree

The positive spread between two Federal Reserve interest rates has been a reliable, riskless stream of income for global lenders

By Mike Bird

The Federal Reserve just announced the death knell for a stream of riskless free cash that foreign banks have enjoyed for much of the past decade.

On Wednesday the central bank said it would cut its Interest on Excess Reserves from 2.4% to 2.35%, and billed it as a technical change. It is a bit more than that to some lenders.

For most of the period since the financial crisis, the interest rate the Fed offered on banks’ excess reserves—holdings above what is required by regulators—has been higher than the Effective Federal Funds Rate, at which financial institutions extend credit to one another. That rate currently stands at 2.45%, but had been equal or lower than the IOER until it began creeping above it in late March.

Since interest on excess reserves was available only to banks, it couldn’t be accessed by other institutions such as money market funds. Such funds would lend to banks at a marginally lower rate, enabling a bank to borrow from them, create reserves at the Fed and get paid to do so.

This wasn’t free money in the sense that some people say low or zero interest rates mean free money. It was literally free money: a regular and riskless stream of income for banks able to engage in the practice.

The Fed doesn’t publish exactly how much of the U.S. banking system’s excess reserves are down to which institutions, but the arbitrage undoubtedly has been more profitable for foreign banks. Unlike U.S. lenders, few are subject to the regulatory levy for institutions requiring deposit insurance. That levy makes borrowing to raise reserves more expensive.

The arbitrage’s best days had already passed. The EFFR had already crept above IOER this year, but the Fed’s move is the final signal that it is killing off the trade. The new rate has been set at a level at which effectively no Fed Funds market lending is conducted, according to data from the New York Fed.

The effect of the arbitrage was never a life or death matter for any banks, but it provided a reliable and welcome stream of free and risk-free income—U.S. dollars, no less—straight from the U.S. central bank to foreign commercial lenders. After 10 years of this bonanza, the least foreign banks could do is send the Fed a “thank you” note.