As the U.S. Government sought to provide support to the economy during its response to the credit bust of 2008-2009 several tools were made available to the Federal Reserve Bank for the first time in its history.
Some controversy arose around the wisdom of programs enabling the government to take unprecedented steps in private asset acquisition and loan-making to companies under the Quantitative Easing programs and Troubled Asset Relief Program. The controversy has died down as the government is largely perceived to have acted responsibly in unwinding or continuing to hold their enlarged positions in private assets during the recent times during which it appears that the economy has found its legs again.
However in the long list of powers granted to Federal Reserve Banks and activities undertaken throughout the response to the credit debacle one tool stands out as untested.
The tool was granted to the Federal Reserve by the Financial Services Relief Act of 2006 and emergency banking legislation pushed through Congress during 2008 activated this new power.
The tool and the new power granted is really quite simple. It's summed up as:
"Regulation D Interest: The Right to Pay Interest on Deposit Accounts Banks Hold with the Federal Reserve"
Regulation D Interest's effectiveness in contributing to sound economic policy and supporting the banking system's contribution to the national interest is yet unknown.
In this article we aren't going to dive into the moral hazard, monetary, economic debate, or political ramifications of this new tool. Instead we're going to focus on learning exactly why JPMorgan (NYSE: JPM) will receive $900 million more from the Federal Reserve than they did last year.
Interest Paid on Bank Reserves in a Nutshell
Regulation D Interest is basically a system for handing out money to the banking sector in order to influence the banks to increase or decrease lending by offering them the opportunity to, instead of lending or funding asset purchases with cash, to earn a return on said cash at a net profit margin of 100%.
The tool clearly ties many publicly traded bank's bottom-line profit to the Federal Reserve's decisions to increase and decrease the Effective Federal Funds Rate.
So let's see how much profit is being delivered to the banks by the Federal Reserve.
The New Tool: Since 2008 The Federal Reserve Now Pays Interest on Bank's "Required" and "Excess" Reserve Deposits
".. [during 2015] the Fed paid about $7 billion in interest to banks, including more than $100 million to Goldman Sachs (NYSE: GS) and more than $900 million to JPMorgan Chase. And since the Federal Reserve's board of governors voted in December to double the interest rate on those reserves to half a percent from a quarter percent, the payments will be even higher in 2016." Rep. Waters of California
Interest payments of $900 million to JPMorgan Chase during 2015 implies that the firm held an average of $360 billion in their excess reserve account throughout the year. If JPMorgan's Excess Reserve holdings remain stable throughout 2016, then December's rate hike from .25% interest to .50% interest paid will result in a contribution of $1.8 billion directly to JPMorgan's bottom line through 2016.
Whereas banks may have previously preferred a higher interest rate environment because they could fit a greater amount of profit into each loan, the banks, in addition, now benefit from higher interest rates because it results in greater risk-free interest payments delivered to them directly from the Federal Reserve.
The size of the interest payments depends on the size of their reserves held in their bank account at the Fed.
Excess Reserves are being held to the tune of $2.7 trillion as reported in August of 2015 by the St. Louis Fed:
$900 Million Dollars' Impact on JPMorgan's Bottom Line
During 2015 JPMorgan earned $24.4 billions in net income. $900 million, or 3.6% of net earnings was gained as interest on reserves held at the Fed. If the bank's earnings from operations and reserve holdings hold pat throughout 2016 JPMorgan will earn $1.8 billion or 7.1% of net earnings through their reserves account held at the Federal Reserve.
The point here is that with any consummation of an interest rate hike by the Federal Reserve, there is potentially a doubly-bullish benefit to the largest bank's incomes.
The Most Predictable Part of the Banking Sector Rallies Associated with Rate Hikes
The interest paid on required and excess reserves has become the most clear reason that bank's benefit from interest rate hikes. This new tool will serve as an unprecedented boost, or cushion (depending on the macroeconomic environment), to banking profits during the next high-interest rate regime under the Federal Reserve.
JPMorgan is expected to enjoy $900 million in additional profits throughout 2016 thanks to December 2015's rate increase from .25% to .5%.
Regulation D Interest paid on bank's reserve deposits is a bullish indicator for banks during times of interest rate increases.
Additional Disclosure: This article represents the opinion of the author as of the date of this article. This article is based upon information reasonably available to the author and obtained from public sources that the author believes are reliable. However, the author does not guarantee the accuracy or completeness of this article. It is merely the author's interpretation of the information contained in the article. The author may close his investment position at any point in time without providing notice. The author encourages all readers to do their own due diligence. This is not a recommendation to buy or sell a security.
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