Fed to pay interest on reserves

[bart]

"The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations"
Source: Fed minutes from Oct 2006



(Draft) Emergency Economic Stabilization Act of 2008:
SEC. 128. ACCELERATION OF EFFECTIVE DATE. Section 203 of the Financial Services Regulatory Relief Act of 2006 (12 U.S.C. 461 note) is amended by striking ‘‘October 1, 2011’’ and inserting ‘‘October 1, 2008’’.




A section of the draft of the bailout bill, which will likely pass even of other sections don't, accelerates a provision of the Financial Services Regulatory Relief Act of 2006 to allow the Fed to pay interest on required bank reserves.

This will allow the Fed to more easily control the Fed Funds rate on a daily basis, and also further weakens the whole idea and positive features of reserves themselves.

[jk]

Re: Fed to pay interest on reserves

bart, could you elaborate on the implications? it looks like just another way to give money to banks and, if anything, makes it easier for banks to hold reserves since they'll be paid to do so.

[Pascal]

Re: Fed to pay interest on reserves

If I understand correctly, this is huge. Before this change the Fed's money pumping has been limited by the Fed Funds target rate. If it pumped too much then it could push the actual rate well below the target rate. This happened last week.

Now with the Fed paying interest at the target rate banks have no need to loan to each other. Therefore the Fed can pump in a gazillion dollars and it should not affect the target rate.

Gentlemen, start your inflation engines.

[bart]

Re: Fed to pay interest on reserves

bart, could you elaborate on the implications? it looks like just another way to give money to banks and, if anything, makes it easier for banks to hold reserves since they'll be paid to do so.

Both of your points are true.

My first element, controlling the daily Fed Funds rate, is the clear public intent or "cover". By paying interest on the reserves, the Fed will much more easily be able to control desired reserve levels. They can literally raise that rate almost instantly and affect the level of excess reserves (that amount over legally required reserves) that banks will hold, hopefully thereby stabilizing them and therefore helping to stabilize the daily volatility in Fed Funds rates during crisis periods (they have varied between 0% and 7% in recent weeks).
But actually paying banks to hold reserves seems quite counter productive to me - if a bank can't see the importance of having adequate reserves to cover their proverbial butts, then paying them to do it is avoiding the basic issue of their lack of understanding of sound banking... let alone anything in the moral hazard area.

Secondly and much more importantly, my read of Section 128 means that the Fed has the power right now (assuming passage) to completely eliminate reserve requirements of any kind. A banking system without reserves of any kind on our checking and demand deposit accounts does not exactly fill me with confidence.
An analogy - its like living in an earthquake zone but not having extra food & water etc. on hand just in case... aka, just plain nutty.

[oddlots]

JP Morgan on the Provision - from Across the Curve

JPMorgan Re Interest on Reserves

September 29th, 2008 2:26 am | by John Jansen | This is the JPMorgan take on the provison of the new law which allows the Fed to pay interest on reserves. It is a much clearer explanation than I offered earlier.
Tucked away in the details of the TARP legislation is a small clause that could revolutionize monetary policy-making in the US and dramatically increase the ability of the Fed to respond to the current financial crisis. The legislation which could go before the House tomorrow has a section that reads: “Section 203 of the Financial Services Regulatory Relief Act of 2006 (12 U.S.C. 461 note) is amended by striking ‘October 1, 2011′ and inserting ‘October 1, 2008′.” The act mentioned granted the Fed authority to pay interest on reserves beginning in 2011, the current legislation proposes to grant that power beginning this Wednesday.
This change would greatly increase the ability of the Fed to expand the size of its existing liquidity facilities. Under current procedures, any time the Fed has provided market liquidity by injecting reserves into the banking system — be it through the TAF, PDCF, discount window lending, lending to AIG, or other forms of Fed lending — the increase in reserves has had to be ’sterilized’ by selling Treasuries, conducting reverse repos, or, more recently, through the novel route of having the Treasury overfund itself to increase its account at the Fed. Those means of sterilization threatened to run up against certain balance sheet constraints: the Fed now has less than $250 billion of Treasuries that it hasn’t lent out through the TSLF and TOP, and the Treasury’s overfunding could eventually bump up against the debt ceiling.
With interest on reserves, the Fed would not have to sterilize injections of reserves into the banking system. Normally, reserve injections need to be sterilized to prevent the fed funds rate from undershooting the FOMC’s funds rate target. With interest on reserves, wherever the Fed sets the rate on its deposit facility would effectively set a floor under the funds rate: anytime the effective funds rate would be below the deposit rate, banks would have an incentive to deposit excess reserves with the Fed. Excess reserves would be ’sterilized’ by banks depositing them with the Fed.
One proposed operating procedure using interest on reserves, called the floor system or the Goodfriend system, would have the Fed set the deposit rate at the FOMC funds target rate and then inject massive amounts of reserves into the banking system — possibly by increasing TAF or similar facilities — and allowing the excess reserves to be deposited with the Fed at the target rate. Following such an operation, the Fed’s balance sheet would contain more risky assets and — on the liability side — more deposits (the monetary base would be roughly unchanged); the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed. The effect on the private sector balance sheet from the TARP is similar, though in that plan Treasury debt takes the place of Fed deposits.
The Fed has not discussed how soon they might implement interest on reserves, one obvious reason being that the proposed legislation hasn’t yet become law. Because this power would be granted roughly contemporaneously with the TARP, the Fed may choose to see how effective the TARP is before setting up a deposit facility as a tool to help address the credit crisis.
————————————————————–
Michael Feroli
US Economist, JPMorgan Economics

[Supercilious]

Re: JP Morgan on the Provision - from Across the Curve

One proposed operating procedure using interest on reserves, called the floor system or the Goodfriend system,....

They have a lot of humor (and unbridled arrogance ) : TARP, Goodfriend

[phirang]

Re: JP Morgan on the Provision - from Across the Curve

They have a lot of humor (and unbridled arrogance ) : TARP, Goodfriend

Been following the house debate, and clearly the republicans are holding out for the following:

1) suspension of capital gains tax
2) suspension of tax on money repatriated to the US

If they can get at least one of these concessions, the bill will pass and the oligarchs will be able to properly privatize the banking system.

[JoeSixpack]

Re: Fed to pay interest on reserves

..the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed.

Is there more exploration possible on this topic ? I dont understand FEDs balance sheet enough yet,... what exactly does make these deposits truly safe ?

And in theory then if the Fed relies on these deposits, can there not be a "run" on the Fed, where banks withdraw their money ?

[D-Mack]

Re: Fed to pay interest on reserves

Others point to the 0% reserves, and I wonder why it was for 2011

Paulson bill also proposes the "Elimination of FASB 157 and 0% reserves". This is just as sketchy as it sounds. FASB or Financial Services Regulatory Relief Act reads:

"Federal Reserve Banks are authorized to pay banks interest on reserves under Section 201 of the Act. In addition, Section 202 permits the FRB to change the ratio of reserves a bank must maintain relative to its transaction accounts, allowing a zero reserve ratio if appropriate. Due to federal budgetary requirements, Section 203 provides that these legislative changes will not take effect until October 1, 2011."

Blah, blah, blah. It's all legal mumbo jumbo to conceal the fact that the banks can continue to operate with insufficient capital, which is why the system is currently blowing up. It all get's down to this: The reason the system is exploding is because the various financial institutions have been allowed--via deregulation--to act as banks and create as much credit as they choose without a sufficient capital base. When one reads about massive deleveraging; this relates directly to the fact that under-capitalized businesses were operating with too much debt in relationship to their capital. That's it in a nutshell; forget about the CDOs, the MBSs, the CDS and the whole alphabet soup of derivatives garbage. They were all inserted into the system so greedy Wall Street landsharks could expand credit without supervision and balance trillions of dollars of debt on the back of a one dollar bill. This is why Paulson wants to suspend the rules which would bring credibility and trust back to the system. After all, that might impinge on Wall Street's ability to enrich itself at the public's expense.

http://www.globalresearch.ca/index.p...t=va&aid=10393

[bart]

Re: Fed to pay interest on reserves

Is there more exploration possible on this topic ? I dont understand FEDs balance sheet enough yet,... what exactly does make these deposits truly safe ?

The "full faith and credit of the US government.

And in theory then if the Fed relies on these deposits, can there not be a "run" on the Fed, where banks withdraw their money ?

Legally, no. Reserves must always be above a certain minimum (at least during audit periods).

The Fed doesn't rely on deposits either, they technically can create however much money they want... and I may have misunderstood your point.

[bart]

Re: Fed to pay interest on reserves

Others point to the 0% reserves, and I wonder why it was for 2011

The Fed plans ahead and also always likes more power & control.

[D-Mack]

Re: Fed to pay interest on reserves

The Fed plans ahead and also always likes more power & control.

Of course and banking without reserves would be heaven for them.

The only thing I could think of that falls into 2011 are 5 year option arm's, or maybe the Fed just thought they could keep the game going longer than just 07/08

[bart]

Re: Fed to pay interest on reserves

Of course and banking without reserves would be heaven for them.

The only thing I could think of that falls into 2011 are 5 year option arm's, or maybe the Fed just thought they could keep the game going longer than just 07/08

I see what you're driving at now - very tough call on why 2011 was the year chosen. I have little clue but since the original bill came out in 2006, some hints are probably available when looking at what was going on then.

[JoeSixpack]

Re: Fed to pay interest on reserves

...the Fed may choose to see how effective the TARP is before setting up a deposit facility as a tool to help address the credit crisis.

48 hours, including a weekend. Not bad !

[phirang]

Re: Fed to pay interest on reserves

from marginal revolution:

Why is the Fed Paying Interest on Excess Reserves?

Alex Tabarrok
Today the Fed starts to pay interest on reserves. The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax. Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed. Overall, however, this is small potatoes.
More interesting is why the Fed. will pay interest on excess reserves. In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets? My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong's terms this gives them an additional tool to do it on the Pan-Galactic scale. In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize. Although paying interest on excess reserves brings this whole operation under the Fed house it's unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.


me: This makes total sense. The fed will try to inveert the yield curve to reflate asset prices?