A Vested Interest in Excess Reserves
With talk about the effects of quantitative easing at the forefront, many analysts are calling for the Federal Reserve to end its policy of paying out interest on excess reserves (IOER). The theory is that the interest on reserves acts as an incentive for banks to keep funds parked at the Fed instead of using them for economically-productive investments. An end to the IOER, it is believed, would drive banks into lending those funds, which would spur economic growth. While that thinking seems sound on the surface, it really is not.
The IOER is not playing any role in attracting excess reserves. Furthermore, the amount of excess reserves held at the Fed does not express in any manner how comfortable banks are lending. Lowering the IOER will not increase growth.
The notion that banks -- including Citibank (C), JP Morgan Chase (JPM), Bank of America (BA), Wells Fargo (WFC), and U.S. Bankcorp (USB) -- are using the IOER for profit-making purposes over lending derives from a failure to understand how the banking sector works in the aggregate.
A Misunderstood Accounting Quirk
When an individual bank decides to issue a loan, the money is lent to a borrower who then spends the money. The seller receives the money and deposits that money in the bank. At no time did a new loan from a bank increase the total size of the monetary base. While funds may trade hands, the overall size of deposits in the economy has not changed.
Thus, the number of excess reserves remains constant throughout the lending agreement.
It is important to note the difference between the velocity of money - which helps dictate the rate of growth and inflation - and the monetary base.
The velocity does not reflect a bank's incentives or behaviors. It is simply a ratio of output over money supply. Money can change hands 100 times, representing a big increase in the velocity - but the money supply would remain constant, absent FOMC actions.
A large expansion in the money supply will almost always cause the velocity to fall. Output growth, from increased lending and other economic factors, simply cannot keep pace with the expansion in the money supply.
A recent note by Federal Reserve economists Gaetano Antinolfi and Todd Keister (2012) explains that the increase in excess reserves is essentially an accounting quirk that develops when the Fed expands the monetary base. It is not a business strategy by banks to maximize profits in lieu of lending.
The key in all of this is how the Federal Reserve maintains its balance sheet. For every asset the Fed buys during a non-sterilized quantitative easing action, it has to record an equal liability.
U.S. Treasury securities
Federal Reserve notes
Deposits held by banks
Source: Federal Reserve Statistical Release H.4.1 - balance as of Aug. 22, 2012
When the Fed decides to expand its balance sheet by buying Treasuries, it needs to increase the hard currency base (Federal Reserve notes) or increase the deposits held by banks.
Note: There is a distinction between hard currency and deposits. Hard currency is literally the total number of coins and paper money in circulation. Deposits are the amount of money held by banks in excess of currency.
Currency is expensive to store - a large vault is needed - so it is more efficient for banks to store deposits electronically. However, because consumers need hard currency for cash payments, banks are required to have currency on hand.
For example, a typical bank may have savings and checking accounts that total $1.0 bln. If the bank holds $0.3 bln in currency, the other $0.7 bln would be recorded as deposits.
Doing More Harm than Good
Since quantitative easing began in late 2008, the Fed has only increased the currency base by about 30%. Meanwhile, the size of deposits in excess of currency held by banks has jumped 6,339%.
The first sizable increase in the size of deposits occurred well before the Fed began paying IOER in December 2008. The increase in deposits actually corresponded with the implementation of the term auctions that followed the collapse of Lehman Brothers.
The same holds true at other central banks around the world.
For example, the European Central Bank lowered the IOER paid on its deposit facility from 25 bps to 0 bps in the beginning of July. Since then, deposits - as a percentage of total ECB liabilities - have trended sideways.
Likewise, the Denmark National Bank reduced the IOER it pays to -0.20% in early July 2012, forcing Danish banks to pay the central bank for their deposits. As expected, the amount of deposits held at the central bank was unchanged at the end of the month.
Since the IOER has no effect on the level of deposits at the central bank, the bigger question is why the central bank pays any IOER.
In an article in FT Alphaville, Cardiff Garcia points out that the IOER actually promotes money market stability and prevents negative interest rates.
When the IOER is positive, banks are able to make a small spread. But when it falls to 0%, banks would begin buying repos, bills, and other short-term instruments with yields above 0%.
Banks do not have the ability to increase the monetary base, so any purchase of short-term instruments would require banks to buy and sell amongst themselves.
Eventually, through arbitrage, all short-term interest rates would fall to 0% or possibly go negative depending on the credit risk.
This becomes a problem for money market funds where the credit risks on commercial paper would now outweigh the minimal returns.
A seizure in the commercial paper sector, similar to what occurred when the Reserve Fund broke the buck following Lehman's bankruptcy, would likely occur.
Federal Reserve Chairman Ben Bernanke alluded to this potential problem in his semiannual testimony before the House Financial Services Committee in July 2010. He stated that lowering the IOER to zero would create trouble in money markets and make it difficult to manage short-term interest rates when the Fed decides it is time to tighten.
A Bad Idea from Beginning to End
The IOER has no bearing on why banks keep their deposits at the Fed and lowering the rate will not impact lending decisions. The analysts who are advocating for changing the IOER do not understand that the run-up in deposits is simply an accounting effect following the buildup in money supply.
Yet, the removal of the IOER could have severe negative repercussions for the U.S. economy.
According to Bloomberg Businessweek: "More than half of Europe's money market accounts by assets have closed because securities they invest in pay negative returns after the ECB cut rates."
A similar situation would likely occur in the U.S., which could cause another 2008-like liquidity disaster. That is obviously something the Fed wants to avoid. Cutting the rate on the IOER at this time would be ineffective to begin with and simply foolish in the end.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.