“And the Fed’s trillions in interest rate risk is supported by only $55 billion of capital; their capital is just 1.4% of assets. They have debt (leverage) that is about 70 times their capital!” Mike Perry

“At this point, you’re probably thinking: “Wait. If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves?” Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money. If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They’d find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.”, Former Vice Chairman of The Federal Reserve, Alan Blinder, “The Fed Plan to Revive High-Powered Money”, WSJ December 11, 2013

“It’s a little scary to me to think that Alan Blinder was a former Vice Chairman of The Federal Reserve System! I have read nearly every one of his WSJ OpEd’s these past several years and frankly many (like the one today below) are just plain wrong. The Fed has a current balance sheet of just under $4 trillion. If they were one of the private banks they regulate, they would rate themselves unsafe and unsound. If you exclude the Fed’s monetary/economic role and government backing and look just at their balance sheet, the Fed is currently a giant hedge fund with a highly-leveraged, risky interest rate bet. About $2 trillion or roughly half of their assets (U.S. Treasuries and Fannie/Freddie MBS securities) have a greater than 10 year life. Another $860 billion or about 23% of their assets are in U.S. Treasuries with a 5 to 10 year life. They have another $860 billion or about 23% of their assets in U.S. Treasuries with a 5 to 10 year life. And yet most of their liabilities are less than one year in duration. And the Fed’s trillions in interest rate risk is supported by only $55 billion of capital; their capital is just 1.4% of assets. They have debt (leverage) that is about 70 times their capital!  As some have pointed out, given the duration mismatch of their assets and liabilities and their leverage, it doesn’t take much of a rise in interest rates before the Fed is insolvent on a mark-to-market basis. Yes, the Fed has a little over $2.4 trillion in excess bank reserves today, but they are not sitting idle as Blinder contends; they are being used to fund about 60% of the Fed’s assets. If the Fed reduces the interest rate they pay the banks on these excess reserves (IOER) or as Blinder recommends, charge the banks 0.25%, he is correct that the banks will take these funds back and the Fed will be forced to sell its U.S. Treasuries and MBS or finance them with reverse repurchase agreement (repos) liabilities. What does that accomplish? If the Fed can’t find enough repos and is forced to sell assets, then we go from QE tapering/reduced purchases (which received a bad market reaction), to zero QE/no purchases, to negative QE/sales, all at once. I imagine that would be a catastrophe and might force the Fed to realize losses (Rates would rise on long-term Treasuries and MBS as the Fed sold, just as they fell as the Fed bought them.) which might cause it to become insolvent. If the Fed is able to replace these excess reserves with repo funding, the Fed’s demand for these types of liabilities (given that there is only three or so trillion in money market funds) might push repo borrowing rates higher. So net, net, not much economic affect on the economy, but lot’s of risk for the already very risky Federal Reserve. Mr Blinder himself notes that his “idea” of charging banks IOER would result in banks pulling excess reserves from the Fed and investing these funds in short-term securities. As I noted already, the Fed is using these excess reserves to invest, albeit in a risky manner, in long-term securities (Treasuries and MBS), which is stimulating the housing recovery through low mortgage rates. Would shifting these reserves from the Fed to the banks and shifting investment from long-term securities to short-term securities be a positive or negative to the economy? My guess is a slight negative in the short-run, but certainly not a material impact. It’s not polite to say, but in my opinion, given Mr. Blinder’s pedigree, he would better serve our Country if he refrained from writing OpEd’s that don’t acknowledge that well-intended Fed and government housing policies (and trade imbalances) were the true-root cause of the financial crisis and don’t provide the right solutions for economic recovery.” Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpts from December, 2013 Bloomberg Article Re. Fed Considering Reducing the “Interest (Paid) On Excess Reserves” (IOER) to Banks:

“In considering reducing IOER, Fed policy makers are revisiting a proposal they have rejected for the past five years, even as it was recommended by economists including former Fed Vice Chairman Alan Blinder.

Blinder argued that reducing IOER would encourage banks to lend out more of the money they now keep locked up at the Fed. That would spur growth and employment as companies use cheap money to hire and invest, he argued. Fed officials disagreed, concluding that such a move wouldn’t provide a powerful boost to the economy.

“The benefits of such a step were generally seen as likely to be small except possibly as a signal of policy intentions,” according to minutes of the FOMC’s October meeting.

“They’re grasping at straws for how to signal their plans for the fed funds rate, and lowering IOER could be part of that,” said Sam Coffin, an economist in New York at UBS Securities, one of the 21 primary dealers that trades directly with the Fed.

Michael Feroli, the chief U.S. economist at JPMorgan Chase & Co., said “I’m not sure what signal” lowering IOER would send, because the benchmark federal funds rate would remain little changed.

Opinion

The Fed Plan to Revive High-Powered Money

Don’t only drop the interest rate paid on banks’ excess reserves, charge them.

By Alan S. Blinder

Unless you are part of the tiny portion of humanity that dotes on every utterance of the Federal Open Market Committee, you probably missed an important statement regarding the arcane world of “excess reserves” buried deep in the minutes of its Oct. 29-30 policy meeting. It reads: “[M]ost participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage.”

As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative, I can assure you that those buried words were momentous. The Fed is famously given to understatement. So when it says that “most” members of its policy committee think a change “could be worth considering,” that’s almost like saying they love the idea. That’s news because they haven’t loved it before.

So what exactly are excess reserves, and why should you care? Like most central banks, the Fed requires banks to hold reserves—mainly deposits in their “checking accounts” at the Fed—against transactions deposits. Any reserves held over and above these requirements are called excess reserves.

Not long ago—say, until Lehman Brothers failed in September 2008—banks held virtually no excess reserves because idle cash earned them nothing. But today they hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis points—for an annual total of about $6.25 billion. That 25 basis points, what the Fed calls the IOER (interest on excess reserves), is the issue.

Unlike the Fed’s main policy tool, the federal-funds rate, the IOER is not market-determined. It’s completely controlled by the Fed. So instead of paying banks to hold all those excess reserves, it could charge banks a small fee, i.e., a negative interest rate, for the privilege.

cat

Getty Images

At this point, you’re probably thinking: “Wait. If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves?” Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.

If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They’d find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.

A second reason for cutting the IOER answers some of the criticisms the Fed has taken for its asset-buying programs called quantitative-easing: Doing so would stimulate the economy without increasing the size of the Fed’s balance sheet. In fact, the Fed could probably shrink its balance sheet.

To understand why, think back to the good old days, when excess reserves were zero. When the Fed injected reserves into the banking system, banks would use those funds to increase lending, thereby creating multiple expansions of the money supply and credit. Bank reserves were called “high-powered money” because each new dollar of reserves led to several additional dollars of money and credit.

The financial crisis short-circuited this process. As greed gave way to fear, bankers decided to store trillions of dollars safely at the Fed rather than lend them out. High-powered money became powerless money.

The Fed compounded the problem in October 2008 by starting to pay interest on reserves. And these days, the 25-basis-point IOER looks pretty good compared with most short-term money rates. If banks were charged rather than paid 25 basis points, they would find holding excess reserves a lot less attractive. As some of this excess central-bank money became “high-powered” again, the Fed would want less of it. So its balance sheet could shrink.

What are the arguments against turning the IOER negative? Over the years, Fed officials have made three, none of them cogent.

One is that cutting the IOER would have only modest stimulative effects. Well, probably. But are there more powerful tools sitting around unused? Besides, there is at least a chance that we’d get more new lending than the Fed thinks.

Second, there is a limit to how far negative the IOER can go. After all, banks can earn zero by keeping paper money in their vaults. So if the Fed charged a very high fee for holding excess reserves, bankers might find it worthwhile to pay the costs of bigger vaults and more security guards in order to keep huge stockpiles of cash. Sure. But a mere 25 basis point fee is not enough incentive for them to do so.

Third, a negative IOER could drive short-term interest rates even closer to zero, as banks moved balances from their reserve accounts into money market instruments. And that, we are told, would wreak havoc in the money markets. Really? Perhaps that was a legitimate concern three years ago, but we have now lived with money-market rates hugging zero for years, and capitalism has survived.

Besides, the Fed paid no interest on reserves for the first 94 years of its existence, the European Central Bank has been paying its banks nothing since July 2012, and the Danes have been charging a fee since then. In no case did anything terrible happen.

That said, suppose the policy failed. Suppose the Fed cut the IOER from 25 basis points to minus 25 basis points, and banks didn’t react at all; they just held on to all their excess reserves. In that unlikely event, cutting the IOER would neither provide stimulus nor enable the Fed to shrink its balance sheet. However, the Fed would start collecting about $6.25 billion per year in fees from banks instead of paying them $6.25 billion in interest—a swing of roughly $12.5 billion in the taxpayers’ favor. Some downside.

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).

Posted on December 11, 2013, in Postings. Bookmark the permalink. 1 Comment.

  1. Reblogged this on Deadly Clear and commented:
    Thank you Mike for the insight. “They have debt (leverage) that is about 70 times their capital!” deserves to be said over and over.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: