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.

Overdraft-chart

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.

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