For all of the talk about negative interest rates and the wacky financial gymnastics that this policy entails, there is a relatively obscure tool that the Fed uses to actually pay interest to big banks for their excess reserves.
Interest On Excess Reserves
The policy that allows the central bank to do this is known as IOER, meaning "interest earned on excess returns." Banks are required to keep 10% of their total deposits held in the form of reserves in order to mitigate the risk of fractional reserve banking. Anything above these 10¢ on the dollar is considered extra, or excess. Right now, 93% of all U.S. bank reserves (totaling $2.3 trillion) are in excess of the requirement.
Like you would on a savings account, member banks earn interest on those excess reserves held at the branches of the Federal Reserve. The main difference is that they're earning 0.5% interest on billions upon billions of dollars.
According to Bloomberg, "Last year, [U.S. Representative Maxine] Waters said, the Fed paid about $7 billion in interest to banks, including more than $100 million to Goldman Sachs and more than $900 million to JPMorgan Chase. And since the Federal Reserve's board of governors voted in December to double the interest rate on those reserves to half a percent from a quarter percent, the payments will be even higher in 2016."
The Problem With Excess Reserves
This scenario of banks reaping hundreds of millions in interest from excess reserves began after the financial crisis. As part of the bailout, the Fed bought up all of the bad debt and toxic assets the banks were holding; instead of paying them directly, the Fed simply credited the banks in the form of deposits.
However, this disrupts "business as usual" for the Fed to set monetary policy. It can't raise rates by selling a large amount of Treasurys, because the excess reserves these member banks hold are so vast that it won't make a difference. IOER is the only avenue the Fed has for setting short-term interest rates higher.
The Rationale for IOER
Although Fed Chair Janet Yellen was grilled extensively about IOER during her testimony in front of Congress, the policy was actually enacted and bestowed upon the central bank by Congress. The measure certainly has helped prop up the financial sector since the Great Recession. Yet, now that the Fed has gone down this path of unconventional methods, it can't quickly turn back. As stated earlier, monetary policy cannot be wielded the same way anymore because IOER has made such measures moot. The only way the Fed could reset things would be to hold a massive sale of trillions of dollars worth of Treasurys, which would absolutely fling markets into chaos.
The Federal Reserve defends its IOER policy, in part, by not giving the banks themselves any say over how much is held as excess reserves for them. The Fed pulls all of the strings in this regard, so a big bank like JPMorgan or Goldman Sachs can't simply hoard additional reserves to boost their interest payment each year.
The Fed itself earns interest on the excess reserves, which are essentially its own assets that it bought from the bank. It remits these interest earnings to the Treasury Department to the tune of over $100 billion per year. These funds go toward reducing the budget deficit.
Evaluating IOER Policy
Some have called the IOER method unfair and overly expensive. No matter how it is constructed, this Fed policy is still more of the same fiat money manipulation that "can distort resource allocation and constrain economic opportunity," as described by Representative Jeb Hensarling. It's essentially a backdoor way for Fed to pass billions in revenue to the Treasury to clean up the bloated budget deficit rather than address the underlying problem.
It's no wonder that IOER has come under bipartisan scrutiny from lawmakers—but, as usual, the problem is the product of both the Congress and the Federal Reserve. It's both groups' responsibility to figure out a way to normalize policy before it's too late.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.