From the American Bankers Association, this is the A BA Banking Journal podcast. Welcome back. I'm Evan Sparks. Today's episode is presented by Intrafi and I'm delighted to be joined by my a BA colleague Jeff Huther, in our office of the Chief Economist. Jeff is an economist and previous Federal Reserve staffer who has a lot of expertise on a variety of eco monetary policy functions.
And one of the things I wanted to talk to him about is a recent a BA data bank post that he wrote for us on the payment of interest on bank reserves. This is obviously a key component of how the Fed conducts monetary policy. There are always proposals in the, in the ether to change what the Fed might be doing in the reserve space.
But before we get to those Jeff, could you kind of just give a, give our listeners for anyone who's not familiar, an overview of the Fed's current approach to paying interest on reserves.
Sure. The rate gets set when the Fed re resets its interest rate policy targets, and it's 10 basis points below the top of the, the fed's range, which is currently at 25 basis point range. The payment reserves. States back to 2008, and the Fed had wanted to pay interest on reserves for a long time. It felt that as though it was constraining its ability to implement monetary policy through open market operations.
So once it got the authority, it, it went straight into buying a lot of of securities. Doing so raise the amount of reserves in the system. That is, that when the Fed buys re securities, it gives banks reserves in, in exchange. So that process of paying for res for securities buying mortgage backed securities and treasury securities and paying. Interest to banks has, has largely been profitable for the Fed until the last couple of years.
When interest rates rose quickly, the securities that the Fed had bought were very low interest rate the average interest rate on their mortgage backed security portfolios around two and a half percent. And recall, they're paying 4%, 4.4% on on reserves. So right now they're in a. A money losing situation. And that's been the, the real motivator for, for proposals to, to stop paying interest as a way to kind of get them out of the hole. They've, they've dug for themselves.
So if the Fed were to stop paying interest on reserves or to reduce the amount it pays on reserves, in order to trim some of these some of these the losses it may be taking, what would the impact on its monetary policy decisions and practices be?
Well, I, I think there are a couple of components. One is that they would have to pretty aggressively reduce the size of their portfolio and that that would probably in involve SA sales as well as letting securities roll off is their current practice. And the reason is that it just stopping to pay interest right now would have a. Huge negative effect on the banking sector in a way that would be destabilizing.
Something like 65% of net income last year is, is roughly the value of the interest on reserves that, that the Fed paid to banks. So you can imagine if, if you took away that, that that those interest payments. That the, the, the banking system would have to react in a pretty, pretty substantial way. Send their deposit rates to zero find ways to avoid holding reserves. And remember, it's a closed system, so there aren't too many ways to, to get around paying interest.
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So moving back to the conversation with. Jeff you know, we are looking at a you know, the, this question of in of paying interest on reserves and the idea being that. The Fed is now taking a loss because of the the mismatch in, in, in the, the change in rates. Would removing interest on reserves actually do anything to help the federal budget?
And, you know, as we look at, you know, congress moving reconciliation bills, I mean, is there, is there anything here that would actually help, help deal with you know, federal budget deficit?
Not, not in the short run for sure. The, the Feds has accu, the Fed has accumulated a, a pretty large deficit over the last few years, and that's they call a defer. The, the accumulation of those deficits called a deferred asset, that that deferred asset is now worth some $200 billion that the, that the Fed would have to. Paybacks essentially pay itself before it started returning money to the US Treasury.
So the question would be how long would would it take for them to, to pay off that, that debt? And the, the question is complicated by, well, what are, what are interest rates gonna be? How quickly is the are reserves going to go down if it were to stop paying interest?
And so you could say for at least some years there would be no, no, no revenue generated from the Fed, even though it would have this a stream of income that wouldn't have any subtraction against it in, in an ongoing sense of a kind of a net interest margin. It would be a very positive net interest margin, but it would, would still. Be used to pay this, this accumulated debt that, that they've incurred.
So we'd be looking at a number of years before we can act. We'd actually see that to this what in your, in your article, it's $216 billion you know, paid off within the, you know, accounting, you, the accounting models that the Fed uses here.
Yeah, yeah, yeah.
And then so, so it's like, all right, so we're not getting. An impact. So if we were to stop paying, we're not getting an impact on a on the budget, we are seeing an impact on the Fed's ability to conduct monetary policy. What is, what, what about the effect of stop of CCing to pay interest on reserves on bank? On bank operations?
I mean, I assume banks are gonna substitute assets if they are if they're not receiving, receiving payment on reserves that are held at the federal, at their, at the Federal Reserve Banks.
Yeah. And that's a, that's a you know, from an economist point of view, that's kind of an interesting question because the, there's so few ways that banks can get rid of reserves that, you know, if in a typical framework, the reserves can be transferred from one bank to another, but they can be neither created or destroyed on the, the, the bank side that's really up to the Fed and how it manages its balance sheet.
Over last beginning in 2013 the Fed created an an out effectively for reserves through some it's called, oh, it's called the overnight reverse repo program or facility that. That program absorbed a couple trillion dollars worth of of reserves in the years during and after the, the pandemic. That program might be a way for banks to receiving interest.
And the way that would work would be that the, the banks that have access to to this program would encourage their depositors to take their money, put it into funds that are then invested in the bank directly in the, in the overnight reverse repo program through the bank or through an affiliated money market mutual fund.
The problem with this ability to shift money into a interest bearing account is that it's really set up for the large banks and the smaller banks don't meet the fed's standards for counterparties. They have to have 30 billion in assets before they even want to talk to you. So it's not an easy program for or it's not a program that would be easy for your, for your typical bank to access and find a way to get interest instead of getting interest on reserves.
So. The big budgetary effect would probably be negated by the big banks moving their, their reserves into this program. The small banks would suffer in terms of not being able to get interest on the reserves and not being able to access the program.
This proposal out there, I have no idea what the people who are advocating for it want, but it sounds like it's something that's just kinda net negative, certainly for the smaller, for smaller community banks, if you are switching the you know, limiting the ability to access interest on reserves. Yeah. Yeah. All right. Well, that was a very, that's a very, it's a very interesting topic as always.
I, I learned something new from you, Jeff, and I appreciate and from, from your colleagues at in the Office of the Chief Economist. For those of you who are listening, you can find Jeff's piece at aba.com/databank or on the ABA Banking Journal website. Go ahead and take a look at that. Very informative. And then we, there's a whole bunch of other information on Abba's website from our Office of the Chief Economist with and from our EE our economic research team. So, go again.
Go ahead and check that out@aba.com. Thanks again to Intrafi and the Banking with Interest podcast for sponsoring this episode. And thanks so much to you for listening. We'll be back with you again very soon.