Reserves (sometimes called bank reserves) are funds held by depository institutions that can be used to meet the institution’s legal reserve requirement. These funds are held either as balances on deposit at the Federal Reserve or as cash in the bank’s vault or ATMs. Reserves that are applied toward an institution’s legal requirement are called required, while any additional reserves are called excess.
Fed paper by Todd Keister and James McAndrews
Why Are Banks Holding So Many Excess Reserves?
The quantity of reserves in the U.S. banking system has risen dramatically since September 2008. Some commentators have expressed concern that this pattern indicates that the Federal Reserve’s liquidity facilities have been ineffective in promoting the flow of credit to firms and households. Others have argued that the high level of reserves will be inflationary. We explain, through a series of examples, why banks are currently holding so many reserves. The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiatives and in no way reflects the initiatives’ effects on bank lending. We also argue that a large increase in bank reserves need not be inflationary, because the payment of interest on reserves allows the Federal Reserve to adjust short-term interest rates independently of the level of reserves.
The FED’s policy tool, interest on reserves (IOR’s or @.25%), the FOMC’s interest rebate on member bank reserve balances (Congress made the taxpayers pay for), has induced widespread dis-intermediation among the non-banks (the most important economic sector in this recession/depression — or 82% of the lending market,e.g., MMMFs, GSEs, etc., Z.1 release). Some instruments: 4 Week Treasury Bills (.05%), Financial Commercial Paper (.10%), Effective Fed Funds (.12%), etc. (today’s quotes = 11/19/2009)
I.e., the intermediaries have shrunk in size & the size of the member banks has remained essentially the same. The non-banks are financial intermediaries – intermediaries between saver & borrower. The member banks are new money and credit creators (they always create new money in the lending process, member banks do not loan out existing deposits).
A trillion dollars + in monetary savings (if you count just the verifiable portion in excess reserves), was siphoned out (via redemptions, etc.), of the non-banks (e.g., hedge funds, investment banks, finance companies, insurance companies, mortgage companies, pension funds, etc.).
I.e., interest-bearing deposits at the financial intermediaries were siphoned out of the economy (in the form of loans and investments at the non-banks (mortgages, etc.). I.e., net debt (or velocity), has contracted (but not net new money).
Non-banks (contrary to Lord Keynes), are not in competition with member commercial banks. Savers never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries.
Shifts from time/savings deposits to other deposit types within the CBs (and the transfer of the ownership of these deposits to the thrifts/non-banks), involves a shift in the form of bank liabilities (and a shift in the ownership of (existing) deposits (from savers to thrifts, et al).
The utilization of these savings by the thrifts has no effect on the volume of deposits held by the CBs, or the volume of their earnings assets. I.e., the non-banks are customers of the member, money creating, depository banks.
The financial press has attributed this to deleveraging. However, the member banks (18% of the lending market, Z.1 release), has suffered no dis-intermediation (just portfolio readjustments).
Monetary savings (savings held beyond the income period), are impounded within the banking system. They are lost to investment, consumption, or to any type of payment (if held in this form). I.e., savings held within the monetary system have a transactions velocity of zero, and are a leakage in the Keynesian national income concept of savings.
Such a “cessation of circuit income” has adverse effects on production and employment, and requires large dosages of money to counter-act.
Thus under one view, the quantitative easing performed by the FED (an increase in legal reserves), has been substantially erased. But we are not done. If the FOMC raised the average reserve ratios on member bank deposits, the volume of required reserves would increase (which if large enough, could induce bank credit contraction), ceteris paribus.
This process is the same as if the FOMC raised the remuneration rate on excess & required reserves, vis a’ vis other competitive instruments and yields. It would also increase the volume of legal reserves, ceteris paribus (which also acts to reduce the monetary system’s lending capacity).
I.e., the BOG increased reserve-deposit ratios by increasing the volume of inter-bank deposits held in the District Reserve Banks, owned by the member banks (in the form of IORs).
I.e., the FED has followed a downward spiraling contractionary policy in the midst of a recession/depression.
Quantitative easing was tried, but there were opposing forces that rendered it immeasurable.
The solution is to redirect savings to the non-banks, and velocity (consumption & investment), will rebound, without unnecessarily forcing prices (stagflation), higher. This re-routing was successful in the housing crisis of 1966 (such targeted redirection is used in a command economy). In 66, both the member bank’s and non-bank’s profits were revived, and the housing market (and the economy along side it), recovered thereafter, etc.
Precisely my point: the Fed cannot pay higher interest on Excess Reserves without raising the target Fed Funds rate (which is the rate paid on borrowing Required Reserves). They will be reluctant to do so at a high unemployment rate. Policy is and will remain asymmetric (towards easing) as long as unemployment is high, regardless of what inflation expectations do. Therefore, the Fed cannot manage inflation expectations unless the economy undergoes a material expansion in real terms.
Bottom line, the Fed is betting on a real recovery, and on the output gap controlling expectations in the meantime. At the same time, it is misinforming the people by arguing that it can manage inflation expectations (by controling Excess Reserves) without raising interest rates.
@David Pearson:
“…That means that banks wanting reserves to support lending can borrow them at .25%.”
Not quite, banks wanting to acquired required reserves would have to pay fed funds and the rate on fed funds (not to be confused with the rate on required reserves) would then float above the excess reserves rate. The fed controls total reserves and the mix between required and excess, so raising the rate on excess reserves, while keeping the rate on required reserves unchanged is equivalent to raising the fed funds rates i.e. tightening policy and “taxing” new lending.
jck,
I’m not sure I understand your point on required reserve interest. Say the Fed raises the rate on Excess Reserves to 1% and leaves the RR rate at .25%. That means that banks wanting reserves to support lending can borrow them at .25%. The Fed would have to provide them with any amount funds such that the rate does not climb above that target Fed Funds rate. Do the banks lend out Excess Reserves at 1%? It doesn’t matter — they have as many (Required) reserves from Open Market Operations as they need to support lending at .25%.
In a sense, the above jibes with what “Flow5″ is saying. Banks don’t lend out reserves. They make loans and either borrow Required Reserves (from the Fed as a system) or use existing Excess Reserves. So if you raise the ER rate but not the RR one, banks just use RR’s to support the loans they make. At a rate of .25% on RR’s they will lend as much as they would have had the ER rate also remained at .25%.
Bottom line, for the Fed to restrain lending, they have to raise interest rates. For the Fed to sell assets, they have to put upward pressure somewhere along the curve: short end if they conduct reverse repo’s; long end if they sell MBS or Treasuries. There is no balance sheet shrinkage or restraint of lending that can occur without raising SOME borrowing cost. The fact that people believe otherwise is testament to the Fed’s rather effective disinformation (“we have other options besides raising rates”) campaign
The member banks do not loan out “excess reserves”.
From a systems viewpoint, “member banks” (as contrasted to financial intermediaries): never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity, or any liability item.
When member banks (MBs) grant loans to, or purchase securities from, the non-bank public (which includes the U.S. Treasury & every person), (except the commercial and the Reserve Banks), MBs acquire title to earning assets by initially, the creation of an equal volume of new money- (transaction deposits) — somewhere in the banking system.
I.e., commercial bank deposits (as well as interbank demand deposits held at the District banks owned by the member banks), are the result of lending, not the other way around.
An individual bank can create deposits up to an amount approximately equal to its excess reserves (unused lending and investment capacity). I.e., while an individual bank is limited to its excess-reserve position, the system as a whole is able to create deposits by a multiple of the total excess reserves in the system.
@johan:
i was referring to excess reserves, specifically, this is what i meant:
“…cut the rate to force the banks to do “something” with the cash instead of having it sitting at the fed as excess reserves.”
total reserves don’t change and if reserves don’t sit at the fed as excess reserves they do as required reserves, i thought that was obvious.
jck, you will not be able to explain what you mean by:
“…cut the rate to force the banks to do “something” with the cash instead of having it sitting at the fed”
Like I said, the banking system *as a whole* can never withdraw money from the Fed, except for coins and notes. Reserves will always be “sitting at the Fed”. If lending in private society expands, some of the reserves will be called required instead of excess, but it will still be “sitting at the Fed”.
“so to say that sweden is charging for excess reserves is technically correct”
Yes, like saying that only mortal people are taxed.
David:
yes, the fed contributes to the freezing of certain interbank markets while making other parts of the system work better like the payments system.
regarding the wsj blog piece, the guest author is thinking in terms of a return to the statu quo ante i.e. reducing the fed balance sheet to where it was before. i think this is off in my lifetime, the balance sheet will stay inflated especially if there are new rules/standards regarding liquidity for banks but the size of the fed balance sheet is not the problem, it’s the required/excess reserves mix that has to be watched.
As an aside, is what this fellow suggested at the WSJ reasonable?
http://blogs.wsj.com/economics/2009/11/03/guest-contribution-fed-likely-to-have-trouble-with-exit-strategy/
Let’s see if I get this right. The system switches from banks borrowing from and lending to each other, to borrowing from and lending to the Fed. What concerns me is that the Fed seems to be playing two roles now. 1) Lending to banks that can’t get funding from other banks during the crisis. 2) Setting the proper interest rate to strike the balance between economic growth and inflation (assuming they can actually do this).
I’m not sure that these two roles are always compatible. There may come a time when the Fed wants to tighten, but it might harm weak banks.
All this is doing is hiding the banks from each other. Things must be much worse than we’re lead to believe if they can’t allow banks to lend directly to each other. Who are they kidding here?
@johan
the ECB has reserve requirements (http://www.ecb.int/mopo/implement/mr/html/calc.en.html)
the Risks bank doesn’t have minimum reserve requirements but has a deposit/lending facility and a repo facility, the deposit being equivalent to excess reserves, they have 3 rates: negative 25 bps for deposits, 0 for repos and 75 bps for lending. so to say that sweden is charging for excess reserves is technically correct.
http://en.wikipedia.org/wiki/Reserve_requirement
The EU does have a 2% reserve requirement. UK and Sweden don’t.
@c
“I think you first have to distinguish between Required Reserves and excess reserves.”
No need. One single reserve dollar at the Fed can switch state between required/excess when the credit issued by the bank to its customers expands/contracts.
“If rates go negative you will see excess reserves decreased.”
Not for the banking system as a whole, unless they order coins and notes.
“Money leaves the Fed in a number of ways, i.e., the fed can buy bonds, like it does in its US Treasury and AGY/MBS buy back programs.”
Absolutely not. All purchase programs *add* to reserves. The Fed pays with new reserves. The Fed would have to *sell* securities or let them mature to withdraw reserves.
The paper tries to explain this.
In the autumn of 2008 the Treasury helped the Fed sterilize reserve expansion, by issuing bills that banks purchased. That decreases bank reserves because payments go from the buying bank’s account at the Fed to the Treasury’s account at the Fed.
@jck
“the swedish charge is on excess reserves”
Bold statement. Do you know or do you guess? It happens to be plain wrong.
There is no such thing as reserve requirements in EU or Sweden. Only capital requirements. The US, China and some other countries have reserve requirements.
@c:
i think excess reserves are here to stay precisely because of the new focus on liquidity.
interest on reserves is a good tool to have but obviously the rate would have to be very low or negative if the objective was to increase bank lending, which is not the case for the fed, the goal being to expand liquidity facilities to counter disruptions in financial markets and prevent future ones.
I guess the questions are:
In light of the the Government’s desire to stimulate lending by private banks, are interest on reserves a smart policy? Do interest on reserves constitute a superflous subsidy to banks, by giving them a number of “unnatural” advantages (for example, in light of increased leverage dollar borrowing vs. new asset bubble, reflected in the inverse relationship between stocks and dollar, banks can also buttress their balance sheets with cash at a reduced opportunity cost)?
Are excess reserves a “bad” thing, in light of the FDIC’s illiquidity, shouldn’t we want banks to stay more liquid than usual?
@johan:
“if rates on reserves go negative, banks will buy t-bills or lend them”
Does NOT affect total bank reserves, just an individual bank’s reserves.
it change the composition of reserves, required reserves increase and excess reserves go down.
@c:
you are correct, the swedish charge is on excess reserves, but only for overnight deposit, the banks can still earn the (positive) repo rate by using the weekly deposit facility. So as somebody said the negative rate applies to a very small portion of excess reserves anyway.
@David Pearson:
the rate is not a floor for fed funds because some entities (the GSEs) are not paid on their reserves. they are 3 rates to consider: fed funds, the rate the fed pays on required reserves and the rate the fed pays on excess reserves, they can all be different.
Johan
I think you first have to distinguish between Required Reserves and excess reserves. Banks are mandated to keep a portion of their deposits on reserves to ensure the liquidity of their deposit base. The problem is that paying interest on reserves creates the incentive to keep an excess over this required amount. If rates go negative you will see excess reserves decreased. You can corroborate this notion by looking at the behavior of other short-term rate instruments vis-a-vis the GSEs. The GSEs hold large amounts of cash (due to their fragile situation), unlike banks in the Federal reserve system, the GSEs DO NOT receive interest on their reserves. Therefore, they reinvest this cash in overnight and short-term instruments such as deposits and REPO(US government/agy/mbs repo). this causes the Fed fund rate to be substantially less than the target on an overnight basis. This is reflected in the Fed Funds future curve, i.e., futures through march 2010 imply funds softer than the current .25 target. If the fed stopped paying interest on reserves or charged interest (negative pay), it is likely that reserves would further pile into depos, repo, discount notes, bills, etc. or perhaps further out the credit curve. In general, charging interest should decrease excess reserves in the Federal Reserve Banking system (the reserves of individual banks make up the reserves of the system)
Money leaves the Fed in a number of ways, i.e., the fed can buy bonds, like it does in its US Treasury and AGY/MBS buy back programs. Currently the AGY/MBS buy back is scheduled to end march 2010 and has a stated target of 300billion if im not mistaken. Moreover the Fed can execute other open market operations, such as Repos with the Dealer community, where the loans cash against collateral. More directly the Fed can lower the reserve requirement, allowing the banks to keep less cash on reserves(within this evironment this would probably be an inneffective step, otherwise we wouldn’t be having this discussion). Furthermore, to the conversation, the excess reserves in the Fed banking system belong to the banks, they can withdraw them if they chose, and invest further out the credit curve with the “push of a button” if you will. coins and notes not necessary.
With respect to negative interest on reserves in sweeden, it is the riskbanks stated goal to charge interest on reserves in order to maitain their 2% inflation target by discouraging hoarding. I havent looked to hard to corroborate your statement that .15% is earned by a portion of reserves, but I would’t argue against it. it is likely that the Riskbank choses to pay interest on REQUIRED RESERVES, and charge interest on excess reserves.
If you raised the average reserve ratios on member bank deposits, the volume of reserves (required or otherwise) would increase, ceteris paribus. If you raised the remuneration rate on excess & required reserves, vis a’ vis other competitive instruments and yields, the volume of legal reserves would also increase, ceteris paribus.
But all is not equal. In today’s domestic money markets, the Central Bank’s “open market power”, can be used to either “tighten”, or “ease”, the banking system’s overall lending capacity (by either increasing or decreasing excess reserves).
I.e., the term excess reserves has become a misnomer. (1) IORs (interest on reserves) now should be classified as part of the member bank’s earning asssets. And (2) the lending operations of today’s member banks are no longer encumbered by legal constraints (i.e., legal reserves are no longer binding & the monetary system’s “expansion coefficient” as a result, varies widely).
@jck
“if rates on reserves go negative, banks will buy t-bills or lend them”
Does NOT affect total bank reserves, just an individual bank’s reserves.
“instead of having it sitting at the fed”
I asked before, how does the money leave the Fed, other than in the form of coins and notes?
“negative rates on reserves has been done in sweden”
The Riksbank has issued certificates earning 0.15% interest where banks place their reserves. Only a fraction of the reserves therefore bears -0.25% interest.
jck,
I believe the interest on reserves rate serves as an effective “floor” on the Fed Funds rate. Therefore, the Fed cannot raise the interest rate on reserves without effectively raising interest rates. Would it do so with unemployment north of 8%?
@Johan:
reserves are deposits at the fed, if rates on reserves go negative, banks will buy t-bills or lend them, that’s the point, cut the rate to force the banks to do “something” with the cash instead of having it sitting at the fed. “paying” negative rates on reserves has been done in sweden.
@David Pearson:
currently, the rates of interest on reserves is the same for reserves and excess reserves, it doesn’t have to stay that way. even if unemployment is high, they can leave the rate on reserves low and increases the one on excess reserves if there is an inflationary threat or a pick up in inflation expectations due to increased lending, i.e. excess reserves are converted into loans at a high rate.
Let’s say the Fed’s interest on reserves was negative. Explain how banks as a whole could withdraw reserves from the Fed with the exception of ordering coins and notes.
This paper is nothing short of ridiculous.
Of course Excess Reserves are not inherently inflationary. As long as the Fed is willing to raise the interest rate on reserves it is able to limit the banks’ willingness to lend them out. Duh. The question is, WILL the Fed be willing to raise the interest on reserves at high level of unemployment? The answer is clearly “NO”. Unless the Fed states that it is willing to trade off unemployment for inflation EVEN AT HIGH UNEMPLOYMENT, then any “Exit Plan” is just a bet that the economy will recover and uenmployment will fall, enabling the Fed to have the flexibility to raise rates. Until that “bet” works out, policy will be asymmetric: at any level of inflation expectations, policy will remain stimulative as long as uenemployment is over 8%. Does anyone really think differently?
They have to get the money to pay bonuses from somewhere! May as well hold it as a reserve until it is time for the employees to get it.
If FAS157, does come back in January, and investors clearly see massive mark to market losses on the financial institutions and banks assets, there will of course be another round of bank runs. Perhaps that is why they are not lending out.
right, except it’s even better than that, the rate of interest on reserves has been set at 25bps since mid-december 2008.
banks are getting paid interest on reserves. Fed Funds target minus 10bps, .15bps. Over the course of 2009, this rate has typically been higher than prevailing short-term mmkt rates, i.e. shorter maturity tbills, dealer repos, discount notes. On a purely economic basis it is cheaper(and safer) for the banks to park their cash at the Fed.
I imagine most depositor’s in banks, in this environment and regardless of the impact on the banks’ balance sheets, would prefer that their savings be placed within a liquid and safe(relative) location like the Fed, as oppossed to being lent out to more volatile loans.
this has nothing to do with capital requirements, reserves are deposits that are not being transformed into loans, they don’t belong to the banks but to customers.
The reserves are required as the banks know full well the asset balances on their books, just because mark to market doesn’t have to be attributed on quarterlies or yearly reports does not mean that the deflationary assets have magically gone away. The banks are up to their eyeballs in defaulting CDO’s, MBS and CMBS. This is why they are running huge excess capital requirements, they know that if FAS157 is reinstated in January then they will have to express to shareholders exactly how much they are in debt and it will be a HUGE amount.
The wall of liquidity is there to protect the banks from the deflationary Real Estate cycle, if and when RE and CRE improve in price, then and only then will there be CPI inflationary worries. The banks need RE and CRE inflation, its the only way they will become solvent again (unless we have a Japan-esque lost decade(s)).