Academic journal article ABA Banking Journal

Rising Interest on Excess Reserves Creates Political Risks for Banks

Academic journal article ABA Banking Journal

Rising Interest on Excess Reserves Creates Political Risks for Banks

Article excerpt

BANKS HAVE BECOME accustomed to taking heat from politicians in the aftermath of the 2008 financial crisis. They should brace themselves, because they could soon be subject to renewed scrutiny as the Federal Reserve raises interest paid on excess reserves.

The Fed started paying banks IOER in October 2008. It is a necessary mechanism as the Fed methodically lifts the fed funds rate off the zero lower bound. Without IOER, the Fed could have a difficult time raising rates as much as it would like. As rates rise, banks would likely lend out the excess reserves they hold at the Fed. Those excess reserves become more profitable to deploy when rates rise. But those large reserves coming into the market would put countervailing downward pressure on market rates. IOER gives the Fed a way to temper that effect by incentivizing banks to keep more of their excess reserves at the Fed than they otherwise would have.

The rate the Fed pays banks on excess reserves matches the fed funds rate and so far the Fed has raised them in tandem. As of October 2017, those rates stood at 1.25 percent. Political risk arises because of the eye-catching extra amount the Fed will pay banks when rates rise further at a quicker pace, as expected.

Banks hold roughly $2.2 trillion in excess of what they are required to with the Fed. If the Fed held the interest rate on these excess reserves constant at 1.25 percent over the next year, it would pay banks approximately $28 billion in 2018. …

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