"Another Tool for the Fed?"

Barry Ritholtz notes:

Another Tool for the Fed?, by Barry Ritholtz: Have you ever even thought about this?

"The Federal Reserve is formally asking Congress for authority -- starting this year -- to pay interest on commercial-bank reserves, in an effort to gain better control over interest rates and more leverage to battle the credit crunch...

In 2006, Congress gave the Fed permission to pay interest on reserves -- the sums banks keep on deposit at the Fed -- but it delayed the effective date of the legislation until 2011 to postpone the cost to the Treasury.

Banks are required by law to hold a certain fraction of their deposits in reserve accounts at the Fed, but receive no interest on these deposits. Having the authority to pay interest would solve two technical headaches for the Fed.

If they earned interest from the Fed, banks would have no incentive to lend out excess reserves for less. That would make the Fed's benchmark federal-funds rate, which banks charge on overnight loans to each other, less likely to plunge below the Fed's official target -- now 2% -- on days when the banking system was awash in cash.

I'll bet this sort of stuff never even entered your thinking . . .

I don't think he is talking to me, but if he's willing, I'll take that bet. It's interesting how much attitudes toward regulation have changed in the two years since that post, "Regulatory Relief for Banking Organizations," was written.

Also, given our recent financial market troubles, the second "technical headache" that is solved is worth noting:

In addition, the Fed could theoretically combat the credit crunch by buying securities or extending loans without limit without causing the federal-funds rate to fall to zero, something that could fuel inflation or distort markets. ...

To combat the credit crunch, the Fed has replaced half the roughly $800 billion of Treasurys it held last July with loans to banks and securities dealers.

If the Fed used up all those Treasurys, it could purchase more, but in the process it would create large quantities of excess reserves. As banks lent out those excess reserves, the federal-funds rate would fall to zero. By paying interest on reserves, the Fed could put a floor under the funds rate and expand its balance sheet to deal with the credit crunch. The Fed, however, has not cited that as the immediate objective of its request.

Comments

[Bruce Wilder]

The Congress should adopt a usury ceiling, before making any other change in banking regulation.

[Jay]

Bruce:

Take a look here... http://www.theobjectivestandard.com/issues/2007-fall/morality-of-moneylending.asp

Although I could be willing to accept a "usary ceiling" if it is set at my ceiling (0.0000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000001% APR).

[Jay]

There is a 1 somewhere way off to the right of where the 0's got cut off.

[skeptonomist]

The Fed had essentially abandoned reserves as a tool, ostensibly in part because it did not give them much control (this is on their website), also because Greenspan had figured out that they didn't really need them anyway. Now it is going to reinstate them, in effect by paying the banks.

Isn't it strange how crises caused by the financial system and Fed policies usually result in actions beneficial to the financial system and extension of Fed power?

[Justice]

Jay..."There is a 1 somewhere way off to the right of where the 0's got cut off."

In days of yore, gold/silver coins were loaned. Lenders got paid back the same purchasing power. If someone loaned her neighbor one day's pay (one silver coin), she got paid back one day's pay (one silver coin). Nowadays, if someone loans one day's pay, she get paid back 1/2 day's pay due to inflation. How can there be justice in Beth borrower paying Sally saver one half day's pay for a loan of a full day's pay?

[Winslow R.]

skeptonomist wrote: "Now it is going to reinstate them, in effect by paying the banks."

Not sure I get what you are saying.

For me the move is a first step in removing variability in the interbank lending market. Borrowing from the Fed window will become the Fed funds target rate and payment on the reserves will soak up the excess. It makes for a tighter system.

Fed power should be increased. Greatly. But in a nonpolitical manner. Everyone with good credit should be treated the same before the Fed window. Every citizen, that is.

No more of these 'special' actions as they damage bank/internationalists/Summers/Rubin credibility.

[Winslow R.]

skeptonomist wrote: "Now it is going to reinstate them, in effect by paying the banks."

Not sure I get what you are saying.

For me the move is a first step in removing variability in the interbank lending market. Borrowing from the Fed window will become the Fed funds target rate and payment on the reserves will soak up the excess. It makes for a tighter system.

Fed power should be increased. Greatly. But in a nonpolitical manner. Everyone with good credit should be treated the same before the Fed window. Every citizen, that is.

No more of these 'special' actions as they damage bank/internationalists/Summers/Rubin credibility.

[jalrin]

This is a blatant giveaway of taxpayer money (the $30 billion interest on federal reserve notes that the Fed pays the Treasury) to the finance sector that has bled this country dry for decades.

If the Fed really wants more control, why not just jack up the reserve requirement and sterilize it by buying treasuries (which helps the people). They would then have more securities to squander in the TSLF.

Additionally, they could ask for permission to extend the reserve requirement to the shadow banking system as a way to rein in these monstrous entities and provide more room for aid to real Americans (the serilization of the above would be a major windfall for the treasury).

[Winslow R.]

jalrin,

The question is where are you headed, and is this a step to get there?

If you believe bank leverage should be reduced, this is a step in the right direction as it could be used to unwind the interbank bank lending system. Banks would borrow from the Fed rather than each other.

Next Step of banking unwind

Private citizens would be allowed to deposit cash at the Fed. Treasury Direct already allows government to compete with Bank CDs for citizen's long-term deposits. Citizen Fed accounts would allow government to compete with Bank accounts for short-term deposits.

[RueTheDay]

"In addition, the Fed could theoretically combat the credit crunch by buying securities or extending loans without limit without causing the federal-funds rate to fall to zero"

This is just nonsense. Paying interest on reserves does not enable the Fed to limitlessly inject reserves into the system without affecting the Fed Funds rate. At some point, those reserves will simply come right back to the Fed in the Fed's interest bearing reserve accounts. And then what's the point, as those reserves will no longer be in the banking system.