The View From Here

Our analyses of topical issues relating to the economy and financial markets.

An Excess of Reserve

July 24, 2012

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  • Bank credit has expanded nicely over the past two years, yet financial institutions continue to hold substantial pools of excess reserves with the Fed.
  • Some suggest that this extended conservatism is hindering the economic expansion, and are calling on the Fed to lower the rate it pays on excess reserves.  The ECB has already taken this step.
  • We think that a cut in the interest rate on excess reserves is unlikely.  The benefits of this strategy may be limited, and the risks it presents could be substantial.

My ancestors came to the United States from Northern Europe, and open displays of emotion in our house when I was growing up occurred rarely.  My wife’s family came to the United States from Southern Europe, and open displays of emotion in her home occurred daily.  It has made for an interesting dynamic in our relationship.

Choosing the right balance between reserve and aggression is a challenge faced in many realms.  For the purposes of this commentary, we’ll focus on the equilibrium that banks seek between holding reserves and aggressively extending credit, and the Fed’s efforts to influence that equilibrium.

The volume of bank lending dropped off considerably after the financial crisis.  But over the past two years, loans and leases have been expanding nicely, and currently stand more than 5% higher than they did 12 months ago.

view from here 07-24-12 chart 1
(Note that the sudden increase in 2009 represented the return of some securitization transactions to bank balance sheets as accounting rules changed.)

As my predecessor Paul Kasriel observed earlier this year, growth in bank credit is highly correlated with growth in domestic purchases.  So the trajectory of bank lending can be an indicator of economic vitality.

As encouraging as the lending picture appears on the surface, the optimism is tempered somewhat by the huge pool of monies sitting idly on bank balance sheets.

view from here 07-24-12 chart 2A large fraction of these amounts, a total of $1.5 trillion, is in the form of excess reserves.  If more of this money was out on loan, the thinking goes, our economy would be doing better.

Since 2009, the Federal Reserve has been allowed to pay interest on these funds (currently at the rate of 25 basis points).  The Fed views the interest rate on excess reserves (IOER) as a lever which could be used to implement monetary policy.  Two years ago, Federal Reserve officials were thinking about how the IOER could be employed to control the expansion of credit in the event that the economy was at risk of overheating.  Raising the rate could encourage banks to keep funds on deposit with the central bank, as opposed to lending them aggressively and contributing to inflation risk.

Today, by contrast, the economy is struggling and our central bank is looking at options to add momentum.  One of them would be to reduce the IOER, which (at the margin) would provide an incentive for banks to lend instead of holding fallow balances.  Earlier this month, the European Central Bank dropped the rate it pays on excess reserves to zero, prompting some observers to call for the Fed to follow suit, or even to move the IOER into negative territory.

Potential Pitfalls
We do not think that the FOMC will take this step.  For one thing, it is unclear that a great volume of new lending will ensue: demand for credit remains modest, with consumers deleveraging, many corporations flush with cash, and both following a conservative strategy in an uncertain environment.  From the supply perspective, banks remain somewhat risk averse themselves.  Credit quality is hard to assess, and capital requirements surrounding lending are in a state of flux.  These factors make it difficult for financial institutions to gauge the pricing and profitability of new business.

Beyond that, a cut in the IOER could create problematic ripple effects in the money markets.  Overnight rates like the Federal Funds rate and short-term repo rates could easily fall to zero or even go negative on some days if the IOER were reduced by ten basis points or more.  Such an outcome could create important distortions or dislocations, particularly for money market mutual funds. 

Lower short-term rates would place a further squeeze on money fund sponsors, which could prompt some to move from a stable unit value to one that varies (this is a nice way to say that the buck will be broken).  Some investors could certainly be expected to find this troubling, and could lead a disorderly flight from this asset class.  Policy makers have been concerned for some time about the potential for systemic instability traveling through this sector (as it did in 2008), and would want to steer clear of this outcome at all costs.

As we’ll discuss later this week, other forms of monetary ease may be more effective with fewer side effects.  So while passion may lead some to call for a cut in the IOER, we think that cool reason will win the day.  That’s been my strategy at home; here’s hoping the Fed has more success with it than I have.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.