Is Bank Profitability Linked To Fed Funds?

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Includes: BAC, JPM
by: Celan Bryant

Summary

In 2008, the Fed started paying interest on reserves and excess reserves. Today, the rate for both is .25%, but it will probably go up this year.

In this piece I look at how much banks stand to profit from this lending arrangement.

If the FOMC sets the fed funds rate to 3% over the next 5 years it will pay $156 billion to banks in interest.

On April 7, the Federal Open Market Committee (FOMC) published their Annual Report. It provides an overview of FOMC operations for 2014. The chart below was taken from the annual report and it shows the amount of excess reserves in comparison to required reserves. In particular, it shows how excess reserves have grown over the last 5 years.

In 2008 the Fed started paying interest on reserves and excess reserves. Today, the rate for both is .25%, but it will probably go up this year. This is because the Fed plans on using the interest rate on excess reserves (IOER) to raise the fed funds rate.

Currently, the fed funds rate trades at a level slightly below the IOER. To increase the fed funds rate the Fed will need to increase the IOER by some amount higher than the IOER. Which begs the question, how much is bank profitability linked to the fed funds and the IOER?

The chart below shows how the rates could change along a rate hike path of .25% each quarter starting with today's rates.

Source: Author's calculations

In this chart the overnight repurchase agreement (O/N Repo) rate sets the floor and the IOER sets the ceiling as depicted below.

Source: Author's calculations

Note that the IOER is higher than the fed funds rate. It's also important to note that the spread between rates is by no means static; it is likely that the spread will vary over time with business cycles (demand for credit). It may also change with the willingness of certain banks and non-banks to make a profit from the spread. Basically, the Fed just needs to pay banks enough to make sure they don't have any incentive to loosen credit conditions.

Prior to 2008, banks were paid 0% on reserves; today they're paid .25 percent, and .25 percent on $2.5 trillion in reserves is $6.25 billion. If the FOMC sets the fed funds rate to 2.25 percent over the next 5 years it will pay ~$156 billion to banks with no reinvestment. At $4 trillion in reserves the amount of interest earned jumps to $250 billion. This is the same amount of interest earned if reserves stayed the same but IOER increased to 4 percent (the historical fed funds average) by 2019.

  2015 2016 2017 2018 2019 Total
IOER 0.25% 0.75% 1.25% 1.75% 2.25%  
Bank Interest Earned $6.25b $18.75b $31.25b $43.75b $56.25b $156.25b

For perspective, according to the FDIC's annual report, total full-year bank earnings were $152.7 billion in 2014.

Bank of America (NYSE: BAC) began including excess reserves in interest bearing accounts beginning in 2014. Prior years have been reclassified to conform to 2014's presentation, however.

As you can see from the chart below, Bank of America made $308 million off of $114 billion in reserves, 70% higher than in 2013. Of course $308 million is nothing compared to $51.8 billion -- BofA's total net interest income -- but it's about to grow as the IOER grows.

JP Morgan Chase (NYSE: JPM) got paid around $1 billion in interest on ~$360 billion in deposits with the Fed. Any eligible bank with reserves held at the Fed is getting paid. Reserves, like Treasuries, represent a risk-free, variable-rate, source of income. As the fed raises rates the IOER will become a more familiar tool of monetary policy, increasingly tied to bank profitability.

New Age monetary policy has given the Fed a considerable amount of power. The ability to charge interest on reserves has transferred ownership of bank reserves from the bank to the Fed. Instead of buying Treasuries to expand the economy, the Fed bought bad loans and paid for them with $2 trillion in excess reserves.

O/N Repo's are the same as fed funds, but at a lower rate. They provide an opportunity for non-banks to make money at the lower rate and for banks to make money on the spread between the IOER and the O/N Repo. As long as this arbitrage opportunity continues, banks will continue to gorge on cheap money. Here's an excerpt from the FRB of Atlanta explaining this relationship:

Banks would respond to the increased profitability by increasing their demand for short-term funds, which would put upward pressure on short-term rates. The incentive to demand more funds would continue until bank funding costs increased to the point where IOER arbitrage is no longer profitable. As a result, if IOER arbitrage were costless, banks would bid up short-term rates until they almost equaled IOER.

The Fed is using this arbitrage to control parked funds at the Fed. With the implementation of the IOER, bank profitability has become inextricably linked to the demand for excess reserves. This presents an interesting investment thesis for banks over the next 5 years as they capitalize on the Fed's need to control excess reserves.

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.