Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Interest on Reserves and Daylight Credit

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Interest on Reserves and Daylight Credit

Article excerpt

(ProQuest-CSA LLC: ... denotes formulae omitted.)

Banks hold reserves in the form of account balances at the central bank and vault cash. The average aggregate reserves of depository institutions in the United States during 2005 was $46 billion. Banks use these reserves to settle payments to other banks (and other participants in financial markets) during the day. In 2005, the average daily value of Fedwire fund transfers-the primary means by which banks transfer funds to one another- was approximately $2 trillion; that is, nearly 50 times the quantity of reserves. When reserves do not pay interest overnight, banks face an opportunity cost from holding reserves overnight. However, if overnight overdrafts resulting from ending the day with insufficient reserves imply a penalty (in terms of higher interest rates or other types of penalties), then holding reserves may also be associated with the benefit of avoiding potential overdrafts. On average, during 2005 banks held a total of $1.7 billion in excess reserves; that is, reserves in excess of required reserves (see Table 1).

In September 2006, Congress passed legislation that authorized the Federal Reserve to pay interest on banks' reserve balances, beginning in 2011. The legislation also granted the Board of Governors additional flexibility in setting reserve requirements for depository institutions after October 1, 2011. According to this new legislation, the Federal Reserve can pay interest on all types of balances, including required reserves, supplemental reserves, and contractual clearing balances, held by or for depository institutions at a reserve bank. Such interest, if authorized by the Board, may be paid at least once each calendar quarter at a rate or rates not to exceed the general level of short-term interest rates.

This new legislation represents a significant change in policy that could affect the choices that banks make about reserve holdings. And, since most central banks conduct monetary policy by intervening in the daily market for banks' reserves, this change could affect the implementation of monetary policy as well by altering the behavior of the demand for reserves. Since paying interest reduces the opportunity cost for a bank of being "stuck" with unused reserves overnight, banks may become willing to hold greater reserves. But the demand for reserves depends not only on this opportunity cost, but also on the benefit of avoiding the need to borrow to make up for a reserves shortfall. It is also likely that the demand for reserves depends on the nature of the payments for which the reserves will be used.

In the settlement of payments during a business day, banks' reserves are supplemented by access to intraday credit from the Fed. If one bank seeks to send funds in excess of its reserve balance through the Fedwire system to another bank, the sender incurs a daylight overdraft. So reserves and daylight credit act as a substitute means of funding transfers during the day. The treatment of reserves overnight, though, can influence the degree to which banks rely on daylight credit to cover their daylight payment activity.

The opportunity cost of holding reserves is most directly affected by the central bank's interest rate policy. A bank's willingness to substitute away from reserves for payment purposes is directly affected by the terms on which the central bank provides daylight credit. In this article, we are interested in the link between these terms and the terms on overnight reserves. We provide a simple model of the demand for reserves by banks (in line with the classic contribution by Poole 1968) and study the implications of paying interest on reserves on the conduct of monetary policy and the use of daylight credit by banks.

One important public policy dimension with regard to daylight credit is absent from our model. Specifically, the model abstracts from credit risk incurred by the central bank. When banks settle payments by drawing on central bank credit, the result is to shift credit risk exposure from private counterparties to the central bank. …

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