Is the Fed Breaking the Law?

[jiimbergin]

via Jesse

sounds like a very good question to me

http://uneasymoney.com/2011/10/10/is...aking-the-law/

Is the Fed Breaking the Law?

Published October 10, 2011 Uncategorized19 Comments

In a comment earlier today to this post, David Pearson shocked me by quoting the following passage from the Financial Services Regulatory Relief Act of 2006:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.

As I said to David Pearson in my reply to his comment, I am flabbergasted by this. The Fed is now paying 0.25% interest on reserve balances while and the interest rate on 3-month T-bills is now 0.01%. Yet the statute states in black letters that the rate that the Fed may pay on reserves is “not to exceed the general level of short-term interest rates.” In fact, as can be easily seen on the Treasury’s Daily Yield Curve webpage, only on rare occasions was the 3-month T-bill rate as high as 0.25% in 2009 and it has been consistently less than 0.20% for most of 2009 and all of 2010 and 2011. Perhaps the definition of short-term interest rates is more than 3-months, but the yield even on a one-year Treasury has been in the neighborhood of 0.1% for months and has been below 0.25% since April. So can anyone explain to me by what authority the Federal Reserve System continues to pay banks 0.25% interest on their reserve balances held at the Fed?
In looking around to see if anyone else has noticed that the Fed seems to be violating the very statute that authorizes it to pay interest on reserves, I found the following post from April 2010 by Stephen Williamson on his blog.

The Federal Reserve Act specifies that decisions about the interest rate on reserves are made by the Board of Governors, not by the FOMC. Obviously Congress did not think through the issue properly when it amended the Act. Since the interest rate on reserves is now the key policy rate, decisions about how to set it would appropriately reside with the FOMC. An interesting section of the Act is this one:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest r ates.

This passage may be vague, but 1-month T-bills are now trading at 0.139% and the interest rate on reserves is 0.25%. The problem is that the Fed cannot do its job and (apparently) conform to the law. The T-bill rate has to be lower now, as the marginal liquidity value of a T-bill is higher than for reserves.

So Williamson also believes that the Fed lacks the statutory authority to pay as high an interest on reserves as it is now paying banks, except that he believes that the Fed would not be discharging its other statutory responsibilities properly if it followed the letter of the law on the rate of interest it may pay on bank reserves. But I admit to being totally unable to understand his reasoning. How can he conclude that the marginal liquidity yield of a T-bill is higher than the liquidity yield on reserves? Presumably in a competitive equilibrium, the pecuniary yield plus the liquidity yield on alternative assets must be equalized. But if banks can earn a higher rate on reserves than they can on T-bills, they hold only reserves and no T-bills. Non-banks, on the other hand, are ineligible to hold interest-bearing reserves with the Federal Reserve System, and must hold lower-yielding, less-liquid T-bills. So the rates on T-bills and reserves held at the Fed are not consistent with competitive equilibrium, and no inference about liquidity yields, premised on the existence of competitive equilibrium, follows from current yields on reserves and T-bills.

[flow5]

Re: Is the Fed Breaking the Law?

The FED is breaking an economic law: The increase to 5 1/2 percent in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves today (i.e., IOeRs @ .25% is higher than the daily Treasury yield curve 2 years out - .28% on 10/14/11).
IOeRs are contractive; & cause dis-intermediation (an outflow of funds from the non-banks - the financial intermediaries between savers & borrowers). IOeRs stop (or retard), the flow of savings into real-investment. IOeRs induce & hasten, debt deflation.

[yernamehear]

Re: Is the Fed Breaking the Law?

I am pretty sure they broke the law with their Maiden Lane facilities (see Wikipedia), and some of the things they did with Fannie and Freddie. Several experts have commented on this, John Hussman being one of them.

[flow5]

Re: Is the Fed Breaking the Law?

The member banks pay for what they already own. They can't raise interest rates to attract savings, & in the process increase the size of the commercial banking system (the system's size is determined by monetary policy). However, if the deposit-taking, money-creating, financial institutions (DFIs), raise their offering rates, they can induce dis-intermediation (cause an outflow of funds), i.e., shrink the size of the non-banks.

IOeRs caused a contraction in the non-banks (& shadow banks) - the most important lending sector in our economy - or pre-Great Recession, 82% of the lending market (Z.1 release, e.g., MMMFs, commercial paper, etc). I.e., when the non-banks shrink so does the growth rate of real-output relative to inflation (& so does job creation). Savings are impounded within the CB system. Only savings transferred thru the non-banks are matched with investment. Money flowing thru the non-banks actually never leaves the CB system. IOeRs exhibit the same contractive force as raising REG Q ceilings in the commercial banks above the rates the thrifts could pay in 1966 (when the thrifts didn't have ceilings).

[mmr]

Re: Is the Fed Breaking the Law?

In this environment, the composition of the banking system's balance sheet (which is as important as its absolute size) is governed primarily by equity capital requirements and the level of demand for loans by creditworthy borrowers.

Cutting the IOER to zero would not, in and of itself, create more creditworthy borrowers. The lower rate on excess reserves would have only a very modest impact in motivating commercial banks to lend if they believe that the marginal loan would produce a poor risk-adjusted return. (Would you really want the banking system to increase lending if the loans were likely to go bad, with losses ultimately absorbed by taxpayers?)

Banks have no interest in holding cash in the form of excess reserves (for obvious reasons, they'd prefer to lend the cash out, or if no such opportunities are available, to push the reserves and related deposits elsewhere.) Banks have to pay an FDIC insurance fee of ~0.13% (on average) on all deposits, including those deposited at the Fed, and have to hold equity against the excess reserves as well. If the IOER is cut to zero, banks will be taking losses to hold excess reserves, and you will see banks competing to get rid of institutional and possibly retail deposits. For example, BNY Mellon recently started charging 13 bps on hot money deposits after they had a significant inflow; this sort of behavior will spread if excess reserves generate outright losses.

The shadow banking system is contracting for a number of reasons:

- Much of the underlying collateral was comprised of bad assets, which continue to be charged off or run off

- Banks stopped lending to the shadow banking sector, not just because of the existence of IOER, but more importantly in response to regulatory and legislative pressure (one of the goals of Dodd-Frank was to increase regulation of the shadow banking sector; taking away this regulatory arbitrage opportunity eliminates one of the major reasons that this sector existed in the first place)

[flow5]

Re: Is the Fed Breaking the Law?

None of that makes any sense when you know that IOeRs were introduced as the functional equivalent of required reserves, used to offset Bernanke’s liquidity funding programs (expansions), on the asset side of the FED’s balance sheet. I.e., quantitative easing, or the FED's POMOs, were sterilized by using IOeRs. For the sterilization process to work, IOeRs by definition, must be contractive. And just like in 66 when the FED had to lower rates to prevent an intolerable slowing in the economy, the FED will have to "tighten" to counteract a lower remuneration rate.

[mmr]

Re: Is the Fed Breaking the Law?

Of all the factors constraining bank lending to the productive economy (as opposed to interbank lending) in the present environment, the rate on reserves is pretty far down the list.

As a practical matter, if the IOER rate were set to zero, you're right in that banks would try to redeploy their reserves into the next highest-yielding short-term investment. The options available basically include secured interbank lending (repo), unsecured interbank lending (selling fed funds), and short-term securities like t-bills. Lending rates in these markets would clearly fall. As many of the shadow lenders also invest in these assets (and in the case of money market funds, are only allowed to invest in these assets), this might actually hurt certain types of shadow lenders.

For example, money market fund sponsors have been absorbing operating losses since ZIRP was implemented. If short-term rates fell by an additional 0.25%, and given that the Fed has committed to keep short rates low through early 2013, fund sponsors may reevaluate whether it makes sense to continue to subsidize a product that may generate losses for years. If anything, a downsizing in MMMFs might force deposits into the commercial banking sector.

The pending Basel III capital rules penalize investment in securities issued by other financial institutions, including shadow lenders, as well as counterparty exposure (unsecured lending or derivatives transactions) to such entities. As a result, excess reserves would be unlikely to flow directly to the shadow banking sector even if the IOER rate were cut.

The rate cut might have a minor impact in stimulating loan demand or reducing interest costs for the productive economy if it also lowered LIBOR or other rates against which loans are indexed.

[flow5]

Re: Is the Fed Breaking the Law?

IOeRs compete with money market “paper”. The financial instruments traded in the money market include Treasury bills, commercial paper, banker’s acceptances, certificates of deposit, repurchase agreements (repos), municipal notes, federal funds, short-lived mortgage and asset-backed securities & Euro-Dollar CDs (liabilities of a non-U.S. banks operating on narrower regulatory margins).

The money market is differentiated by its position on the yield curve (i.e., short-term borrowing & lending with original maturities from one year or less).

“a downsizing in MMMFs might force deposits into the commercial banking sector” That’s not possible. MMMFs are the customers of the CBs.

“excess reserves would be unlikely to flow directly to the shadow banking sector” The correct way to describe any flow to an intermediary financial institution is to say that newly created money:- flows through the non-bank, e.g., the shadow banking system (the funds actually never leave the commercial banking system).

If the remuneration rate was lowered, the utilization of the bank’s excess clearing balances would result in the creation of new money & credit. Bank credit would take the form of investments (heavily weighted in governments), rather than loans (for which there is little consumer or business demand). But since the member banks can’t find more attractive earning assets, they continue to hold balances which don’t circulate, & don’t require Basel II regulatory capital.

The 1966 precedent is clear. Decrease the size of the non-banks & real-output falls.

[metalman]

Re: Is the Fed Breaking the Law?

per bill black are there not 1000x criminals roaming free post financial crash? mebbe bernanke cut a few corners to save 'the' world... wtfc?

[flow5]

Re: Is the Fed Breaking the Law?

Facilitating a shift in the flow of funds through the "competing" non-banks will collectively improve the net earnings of the commercial banks. Proper public policy is to get the CBs out of the savings business. Proper public policy is to eliminate IOeRs.

[c1ue]

Re: Is the Fed Breaking the Law?

Just as an intellectual experiment: doesn't the fact that we have low interest rates incentivise banks to stick to safe but profitable investments, whether they be IOERs or T-bills/inter-bank lending?

Or put another way: if banks exist to leverage the differential between long term deposits and short term lending, doesn't a very low interest rate change the need to indulge in risky, but more profitable lending in order to make a profit?

This is maybe incoherent, but what I'm trying to ask is: if we understand that small business is risky lending, but that it can be profitable due to the higher rates of return (interest and/or equity) involved, does the profitability of this type of risky lending decrease as interest rates paid on deposits fall toward zero?

In normal times a bank *must* generate excess income over what is paid to depositors - in a real sense it is then forced to engage in riskier lending practices in order to survive.

In a zero interest period which extends to the foreseeable future (i.e. little or no payments out for interest on deposits), plus an arguably riskier lending environment associated with recession, plus 100% safe existing income from reserves, is there any point in engaging in riskier lending?

[aaron]

Re: Is the Fed Breaking the Law?

Just as an intellectual experiment: doesn't the fact that we have low interest rates incentivise banks to stick to safe but profitable investments, whether they be IOERs or T-bills/inter-bank lending?

Or put another way: if banks exist to leverage the differential between long term deposits and short term lending, doesn't a very low interest rate change the need to indulge in risky, but more profitable lending in order to make a profit?

This is maybe incoherent, but what I'm trying to ask is: if we understand that small business is risky lending, but that it can be profitable due to the higher rates of return (interest and/or equity) involved, does the profitability of this type of risky lending decrease as interest rates paid on deposits fall toward zero?

In normal times a bank *must* generate excess income over what is paid to depositors - in a real sense it is then forced to engage in riskier lending practices in order to survive.

In a zero interest period which extends to the foreseeable future (i.e. little or no payments out for interest on deposits), plus an arguably riskier lending environment associated with recession, plus 100% safe existing income from reserves, is there any point in engaging in riskier lending?

Isn't that exactly what they are doing?

"When you can borrow money for nothing, and lend it back to the government risk-free for a few percentage points, you can COIN MONEY. And the banks are doing that. According to IRA, the "net interest margin" made by US banks in the first six months of this year is $211 Billion."

http://www.businessinsider.com/what-...-about-2011-10

government-guaranteed-securities.jpg
freemoney.jpg
excess-reserves-earning-interest.jpg

[flow5]

Re: Is the Fed Breaking the Law?

"Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact. This means that on basic lending operations a commercial bank MUST EARN a net interest margin of 3.15 percent in order to “BREAK EVEN.” " -- John Mason

Operation Twist's objective of "flattening the yield curve" doesn't incentivize the banks to make new loans. Neither does inverting the short-end of the yield curve. It's best to fire Ben Bernanke

[c1ue]

Re: Is the Fed Breaking the Law?

Isn't that exactly what they are doing?

"When you can borrow money for nothing, and lend it back to the government risk-free for a few percentage points, you can COIN MONEY. And the banks are doing that. According to IRA, the "net interest margin" made by US banks in the first six months of this year is $211 Billion."

I was asking the question because while we do know the banks are not lending, we don't necessarily know why.

It could be because of a structural issue as I noted above, or it could just be because of massive shadow inventory and as yet hidden toxic loan losses.

I figured perhaps mmr and/or flow5 might have some views on this subject.

"Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact. This means that on basic lending operations a commercial bank MUST EARN a net interest margin of 3.15 percent in order to “BREAK EVEN.” " -- John Mason

The question then is what the excess reserves are vs. the denominator of the expense ratio.

The expense ratio only applies to actual loans made; presumably if excess reserves are 12x or more of outstanding loans, then any additional excess reserves are free money.

Of course I'd think the reality is much more complicated. For one thing, does the expense ratio shift as the prime interest rate changes? 10% prime vs. say 13.5% lending rate vs. a 7% CD interest payment rate is potentially very different than 0.25% prime vs. 4.5% lending rate vs. 1%? CD interest payment rate.

[mmr]

Re: Is the Fed Breaking the Law?

All else equal, lower deposit or borrowing costs would tend to increase the profitability of a given loan. If a bank makes lending decisions based on a particular risk-adjusted return target, with lower funding costs, the return on a given loan would increase. You would expect more loans to exceed the return target (i.e., lending should go up.)

With small business lending, there are a couple of factors that may offset the benefit of lower funding costs:

- In this economy, the probability that a given small business loan will ultimately go bad (e.g., the business will fail) has increased. Banks make educated guesses about this likelihood and include that in their lending decision. Fewer loans will exceed a bank's targeted return once this perceived or actual risk is taken into account, so all else equal, fewer loans will be made.

- Many small business borrowers pledge personal assets, including a lien against their homes in some cases, to obtain loans. This would reduce the risk to the bank, basically by converting at least a portion of the loan into a mortgage. If the business ultimately fails, the bank would be able to use the pledged assets to offset part of their loss. Banks factor this into their lending decision, obviously.

However, as real estate prices have dropped, fewer potential business borrowers have other assets where they still have equity to borrow against. (If you're underwater on your mortgage, no one will give you a home equity loan.) If the bank has to rely just on the cash flows from the business, which are less certain, to make their lending decision, fewer loans will be made.

There are many other factors that could be involved in limiting bank lending to one degree or another:

- Capital requirements for banks have increased, i.e., banks generally have been under pressure to reduce leverage, some more than others

- As real estate prices fall, overall real estate loan balances have to fall as well, unless banks are willing to make loans exceeding the value of the underlying real estate

- Some large businesses that experienced the tight liquidity conditions of Sept/Oct 2008 decided to protect themselves against a similar situation in the future. They retained more of their earnings in the form of cash and borrowed in the debt markets to reduce their reliance on banks. (There are certainly many other factors that have contributed to the large corporate cash stockpiles.) These corporations are increasingly self-funding, and have much less need to borrow from banks.

Loan volume in some areas such as lending to mid-sized businesses has actually stabilized or begun to grow, but the decline in real estate loans, the biggest category by far, is still dragging down the overall total loan volume.