Excess Reserves and Intraday Credit

In my 2008 post, Interpreting the Monetary Base Under the New Monetary Regime, I argued that the massive increase in bank reserves was neither a necessary harbinger of inflation (as people on the right feared) nor a sure sign of a liquidity trap (as people on the left claimed) but rather represented, at least in part, a sensible aspect of the new regime of paying interest on reserves. I wrote:

 When no interest was paid on reserves banks tried to hold as few as possible.  But during the day the banks needed reserves – of which there were only $40 billion or so – to fund trillions of dollars worth of intraday payments.  As a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit.  Thus, in essence, the banks used to inhale credit during the day – puffing up like a bullfrog – only to exhale at night.  (But note that our stats on the monetary base only measured the bullfrog at night.)

Today, the banks are no longer in bullfrog mode.  The Fed is paying interest on reserves and they are paying at a rate which is high enough so that the banks have plenty of reserves on hand during the day and they keep those reserves at night.  Thus, all that has really happened – as far as the monetary base statistic is concerned – is that we have replaced daylight credit with excess reserves held around the clock.

A post today at Liberty Street Economics, the blog of the New York Federal Reserve illustrates and explains how the excess reserves have reduced transaction costs in the payment system and risk to the Federal Reserve.


The last chart shows the level of intraday credit extended by the Federal Reserve to Fedwire participants, measured as the daily maximum amount extended by the Federal Reserve. There has been a dramatic decline in the amount of credit extended since the expansion of reserve balances in October 2008. The reduced level of daylight credit has the benefit of reducing the risk exposure of Federal Reserve Banks, as well as the Federal Deposit Insurance Corporation’s (FDIC) fund. Indeed, the expected losses to that fund would be greater if some of the assets of a failed bank had been pledged to a Federal Reserve Bank to collateralize a daylight overdraft, as the collateral would not be available to pay other creditors of the bank. With a greater amount of reserves in the system, banks largely “prepay” for their liquidity needs by maintaining large reserve balances with which to fund their outgoing payments.


So the Fed is paying even creditworthy counterparties to prefund transactions to reduce its risk to less creditworthy counterparites? It would be nice to see a cost/benefit analysis to verify that this makes sense.

Is the fed moving us to a quazi-rothbardian 100% reserve scheme?

Maybe I'm missing something. How does paying banks an interest rate not increase M?

It does increase M, but it drops V a lot.

If it increases M, but decreases V, what the hell is the point? And what happens when V eventually increases? Bernanke wants to keep printing like a jackass till 2014. My understanding of econ is elementary at best, but my question is what's the point of goosing the economy with a zero interest rate policy if what you want is for the banks to hold their excess reserves instead of lending it out?

As Norman Pfyster suggests, the Fed's risk will vary greatly across banks: the banks to which it offers daylight overdrafts will vary greatly in their financial conditions. A more targeted approach to reducing the Fed's risk would seem appropriate.

And how much does it cost the Fed to pay interest on reserves? It is paying 0.25% per annum, and thereby inducing the banks to hold more than $1 trillion in excess reserves, for an annual cost to the Fed of more than $2.5 billion. Is the reduction in the Fed’s risk worth this much?

$2.5B seems like a hell of a bargain if it successfully insures against the sort of cascading breakdown of high-powered finance in 2007-2008. Most estimates of the costs of the financial crisis, insofar as they're measurable, run into the multiple trillions of dollars.

To make the math really simple, let's say a big financial crisis might do $5T worth of damage to an economy. An annual insurance cost of $2.5B is 0.05%. Seems downright reasonable to me.

+1 to MikeDC

But whenever they eventually start raising rates again, will the have to raise the interest they pay on reserves? I guess they'd have to if they want to maintain the effects.

But as a last resort, couldn't they lend them money?

Hey, that has a nice ring to it, lender of last resort, somebody write that down.

I honestly don't know. However, I don't think they would do so without limit. Since the Fed was also the primary intraday creditor under the old regime, the IOR policy gives them a means to control the amount of leverage banks hold on "both ends".

Old regime:
Rate increase -> Banks borrow from Fed, reduce their own reserves, become over-leveraged. A Fed that cut off credit in this situation causes a panic because everyone is reliant on the credit window for intraday lending to cover themselves.

New regime:
Rate increase -> Banks first reduce their own reserves, but (hopefully) Fed doesn't offer cheap credit to mask liquidity problems. Fed can raise IOR to slow down over-leveraging problems, and extend credit on less favorable terms.

In short, I think it gives them another tool, and makes them slightly less likely to really screw things up.

"another tool, and makes them slightly less likely to really screw things up."

Assuming competence...

Mike, it is misleadling to simplify so much, or at least to leave that "if" in the first line unexplored. $2.5B of insurance to protect against $5T of damage seems great. However, this benefit of interest on reserves should be questioned for two reasons:
(1) We cannot be sure how much damage the financial crisis itself caused; people blame many causes for our economic difficulties since the start of the financial crisis.
(2) We cannot be sure if $2.5B of interest payments would have prevented the last financial crisis, or a future crisis. It may seem downright reasonable to you, but how should the rest of use judge the probability? Is it as simple as saying paying 0.05% is worth it without further inquiry? A large number of policies could be justified with such a rationale.

Also, the cost of the program is unclear.
(3) There may be negative unintended consequences that are being lost in the $2.5B pricetag. For example, if paying interest on reserves is contractionary, then this tool may lead to more contractionary monetary policy. Having extra tools may enable the Fed to point to other indicators and cover up its true policy stance. Or, in other words, assuming that IOR is a good tool for the Fed to use does not tell us whether the current IOR policy is good.

This exactly.

Of all the tripwires and pitfalls from 2008, insufficient bank reserves seems nowhere near the top of the culpability list.

That's what I was going to try to say, although I don't think I could have done as well.


Also, the IOR by definition has to be less than the overnight Fed Funds rate. This actually didn't happen right after Bernanke announced IOR because banks weren't used to it, but now banks never lend to each other only for more than IOR.

So what would have happened during the credit bubble if the Fed was paying IOR at 0-0.25 basis points below the overnight rate? It's hard to see what would have been different.At that point, the banks would have been indifferent in credit risk of the Fed vs. credit risk of overnight lending to other banks. As long as banks had a tiny bit higher rate than IOR, the IOR would have generated zero excess reserves. Why earn a few basis points less just to protect yourself from Goldman Sachs going under tomorrow? Nobody would really think GS would go under tomorrow.

In the end the overnight rates would have been the same assuming the Fed wanted the same inflation/NGDP policy outcomes. Banks would have still lent to each other at a bit higher than IOR and then they would do something with the cash other than leave it with the Fed and lose money on it. IOR only blows up cash reserves when banks see no lending opportunities that due better due to low NGDP expectations. Otherwise a bank will be doing shareholders a disservice by not lending money above IOR or lending to a bank above IOR who will then lend the money. Leverage is the same in normal times and IOR has no effect.

Therefore, the ONLY thing the IOR serves to do is contractionary policy. That's a good thing if you want to reduce V, but it's a very odd thing to do in today's liquidity trap.

And what if the Fed gets it WRONG like they've been wrong about the housing bubble and inflates the economy beyond what they were hoping for? What's the cost to the economy then?

Furthermore, there is no such thing as insurance against financial crises in an economy that's been hijacked by the orgy between Wall Street and the government. I would have a different view if we had free markets, but we don't.

"With a greater amount of reserves in the system, banks largely “prepay” for their liquidity needs by maintaining large reserve balances with which to fund their outgoing payments."

Is anybody else uncomfortable with the mindset that banks "prepay" by way of the Fed paying banks IOR? Maybe I am misunderstanding the context.

My apologies if I don't understand, but while it's true that little has happened to the "monetary base statistic" doesn't this imply a significant contraction in the effective monetary base (i.e., the base during the day)? Am I missing something or doesn't the disappearance of the "puff" mean tighter money?

Yes. Another way of phrasing it is that IOR is a payment to banks in exchange for them taking money out of the effective monetary base [is that the right term to use here?] and holding it as reserves.

If you and I are right, why is that not a very bad thing in an economy that is growing more slowly than desired?

Short answer: it is bad.

Less short answer: it is not necessarily bad because the Fed has the power to make an offsetting expansionary move to monetary policy. But it is bad because the Fed is failing to fulfill its dual mandate and IOR, a contractionary policy unheard of by most of the public, adds to the difficulty of publicizing that failure.

Interesting thought, and makes sense. However, the graph shows daylight credit peaks at $160B. Excess reserves are about $1.6T. So that accounts for 10%. What about the other 90%?

Watching the weekly changes in the Fed balance sheet (yeah, I have no life), it looks like there is a strong correlation between changes in ER and treasuries and the federal government (deposits from the US Treasury). I haven't actually run the numbers (yeah, I have a life), but it looks more like the Fed is using the big banks to suck in cash when it needs it, and park it when it doesn't.

This would argue that ER is more of an indicator of a blurring of the lines between banks and the federal government, with the Fed playing the role of aggregator/intermediary.

Of course, since I haven't actually done the full analysis, and subjected it to peer review, I could be completely wrong. This doesn't mean I'm not totally committed to my narrative; in fact, anyone who disagrees with me is evil and a tool of big corporations or big government. Or both.

Isn't that the way modern financial punditry works? ;-)

Love MR. Keep up the rich bloggy goodness.


"the massive increase in bank reserves was neither a necessary harbinger of inflation (as people on the right feared) nor a sure sign of a liquidity trap (as people on the left claimed)"

The first statement seems sensible and correct because fed "printing" got stored/"hoarded" in reserves ($1.6 trillion minus a max of $160 billion), so had no impact on demand for real goods.

The latter seems less so, depending on how you define "liquidity trap." It does seem to demonstrate that the Fedly printed money was/is not being lent out. So pushing on a string.

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