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The Federal Reserve pays US and foreign banks about $2.2 billion more each year than needed to maintain the current level of average interest rates. Congress and the Fed should take steps to end these unnecessary subsidies.
Last week's transportation funding bill drew attention to the relatively high dividends that the Fed used to pay US banks. The bill redirected a portion of these dividends into the Highway Trust Fund.1 The Congressional Budget Office estimates that this change will increase revenues to the Highway Trust Fund by around $500 million per year in 2016 and 2017.
US banks opposed the reduction in their dividends, but a reasonable case can be made that the high dividend rate was a subsidy from the Fed and that Congress was justified in using some of that money for other purposes. However, a much larger subsidy from the Fed to the banks has gotten little attention. The Fed is currently paying 0.25 percent on $2.5 trillion of bank reserves, which is a higher rate than the 0.05 percent it pays on reverse repurchase agreements (RRPs).
Both reserves and RRPs are safe, short-term investments in the Fed. A wide range of institutions can hold Fed RRPs, including banks, money market mutual funds, government-sponsored entities, and securities brokers. However, only banks can hold reserves that pay the higher interest rate. Relative to what other institutions receive, banks are getting excess payments of about $5 billion per year, or ten times what they are losing to the Highway Trust Fund.
Why does the Fed pay banks more than other institutions? Historically, the Fed paid banks less on their reserves (actually zero) than it paid on RRPs. Banks held the reserves to meet legal requirements and to conduct payments. But the zero interest rate meant that reserves were effectively a tax on banks. It never made sense to tax banks on reserves, but it also does not make sense to subsidize reserves either.
Given the large expansion of its balance sheet in recent years, the Fed has to pay interest on most of its liabilities in order to maintain steady growth with low inflation. Making such payments does not, by itself, constitute a subsidy.2 However, the manner in which the Fed has decided to configure its tools means that the Fed has chronically paid banks an above-market rate on their reserve balances.
Last year, Brian Sack and I proposed that the Fed make greater use of its RRP facility and set equal rates of interest on RRP and reserves. If the Fed were to equalize these interest rates at 0.15 percent, the effective stance of monetary policy would be roughly unchanged (a loosening through the banking system would be offset by a tightening through nonbanks). The Fed would save more than $2 billion per year in expenses.
One argument against equalizing the interest rates on reserves and RRP is that banks have to pay an assessment to the Federal Deposit Insurance Corporation (FDIC) based on how many assets they hold, and that other financial institutions do not have to pay this fee. The issue of regulatory treatment of different types of financial institutions is a complex one. It may be a good idea to exclude bank holdings of reserves from the base of the FDIC fee, which would require a minor revision of the Dodd-Frank Act.3 Alternatively, the FDIC could adapt the complicated formula it uses to calculate its fees to reduce the marginal cost to banks of holding reserves. But it does not necessarily follow that the Fed should offer different interest rates on comparable instruments in order to undo the effects of financial regulatory policy. In any event, the 0.2 percentage point spread between the rates of interest on reserves and RRP is noticeably larger than estimates of the marginal FDIC fee for most banks, which range from 0.05 to 0.1 percentage points.
A further twist is that foreign banks operating in the United States do not have to pay any FDIC fee if they do not accept deposits. In order to participate in the US payment system, foreign banks can hold reserves; they receive the same interest rate on their reserves as US banks. It is not a coincidence that a disproportionate share of reserves (nearly $1 trillion) is held by foreign banks that do not pay any FDIC fee on these reserves. At present, foreign banks are earning nearly $2 billion per year more on their reserves at the Fed than they could earn on RRP or equivalent investments. Excluding reserves from the base of the FDIC fee would put US and foreign banks on a level playing field.
The subsidy to US banks under the Fed's current policy framework is meaningful in size and warrants further scrutiny. The subsidy to non-deposit-taking foreign banks is proportionally even larger. Moreover, the volume of these subsidies to the banking system has the potential to increase when the Fed starts to tighten policy, most likely next week. To avoid increasing subsidies, the Fed needs to raise the RRP rate by an amount at least equal to any increase in the interest rate on reserves. To reduce subsidies, the Fed should raise the interest rate on RRP by more than that on reserves. Congress could help by excluding bank reserves from the base of the FDIC fee on banks.
Notes
1. By statute, the Fed formerly paid a fixed 6 percent dividend to US banks that nominally "own" shares in the Fed. (The shares convey no voting power.) Now the banks will get a lower return tied to the yield on US Treasury bonds.
2. Indeed, the Fed has had record earnings since 2009 because of income on the assets that correspond to these liabilities. Fed earnings are remitted to the US Treasury each quarter.
3. More comprehensively, one could exclude all short-term claims on the federal government, including Treasury bills, on the grounds that these assets pose no risk to the FDIC. The FDIC might have to raise fee rates slightly to make up for the reduced fee base. This change could pose a political challenge because reserves are held mainly by larger banks. Politically powerful small banks might face higher fee rates with little reduction in their fee base. Note that small banks (those with less than $10 billion in assets) were exempted from the loss of dividend revenue in the recent transportation bill.
