It’s of course true, as any money and banking textbook will affirm, that banks cannot alter the total quantity of reserve balances simply by trading them for other assets, as doing so only transfer the balances to other banks. But the question isn’t whether a lower IOER rate would reduce total reserves. It’s whether a lowered rate can result in a lower quantity of excess reserves. The answer to that question is “yes,” because, as the same textbooks also explain, as banks trade unwanted reserves for other assets, they also contribute to the growth of total banking system deposits; the fact that unwanted reserves get passed on like so many hot potatoes only makes deposits grow that much more rapidly. The growth of total deposits serves in turn to convert former excess reserves into required reserves, where “required” means required either to meet minimum legal requirements or for banks’ clearing needs.
That, at least, is what always happened before the Fed began encouraging banks to cling to excess reserves. For example, as the chart below shows, prior to October 2008, banks routinely disposed of unwanted excess reserves in the manner just described, thereby keeping system excess reserves at trivial levels, and doing so despite additions to the total supply of bank reserves that were, by pre-2008 standards at least, far from trivial.
It follows that, when banks hold a large quantity of excess reserves, that fact actually conveys very significant “information about their lending activities.” Specifically, it tells us that they have refrained from engaging in such activities to some considerable extent.
In reply to these criticisms, Mr. Keister has suggested (in personal correspondence) that, IOER or no IOER, the unprecedented scale of the Fed’s post- Lehman balance sheet growth would have rendered the traditional means by which banks disposed of unwanted excess reserves inoperable, because banks couldn’t possibly achieve the expansion in their total assets and deposit liabilities required to convert so vast an increase in total reserves into an equally vast increase in required reserves. But this counter-argument is also contradicted by relevant historical evidence, consisting of instances of hyperinflation in which central banks expanded their balance sheets on a scale much larger still than that seen in the U.S. since 2008. During the notorious Weimar hyperinflation, for example, the (proportional) growth in German bank reserves far exceeded that witnessed in the U.S. since Lehman’s bankruptcy. Yet, according to Frank D. Graham (1930, p. 68), Germany’s banks, far from accumulating excess reserves, increased their lending more than proportionately. “It would appear,” Graham writes, “that the commercial banks extended loans throughout the period of post-war inflation considerably in excess of a proportionate relationship with the increase in the monetary base. … The increase in deposits issuing from loans was especially marked in 1922 and till stabilization in 1923.”
It doesn’t follow, of course, that, had it not been for interest on excess reserves, the Fed’s post-Lehman asset purchases would have led to hyperinflation. Instead, Fed officials would have not have felt compelled to purchase as many assets as they did; in any event, they would have stopped purchasing assets once confronted with evidence that the inflation rate was in danger of exceeding its target. As it was, by relying on IOER to discourage banks from dispensing with excess reserves, the Fed ended up falling short of, instead of surpassing, its inflation target. That outcome came as a surprise to those accustomed to the workings of the Fed’s traditional monetary control framework. But in the context of its new IOER framework, any tendency for the Fed’s asset purchases to raise prices would itself have been surprising.
V. c. Reserve Demand and Opportunity Cost
Final proof, should it be needed, of the bearing of IOER on banks' willingness to accumulate excess reserves comes from consideration of how that willingness varied with changes in the relationship between the IOER rate and corresponding market rates. If banks' demand for excess reserves is driven by the yield on such reserves compared to that on other assets, then the banking system excess reserve ratio—the ratio of total excess reserves to total bank deposits—should vary with the difference between the IOER rate and comparable short term market rates, such as the overnight LIBOR rate. As the next chart shows, this has indeed clearly been the case.
VI. IOER and Interbank Lending
As we’ve seen, when the Fed began paying interest on bank reserves, its immediate concern was to keep its emergency lending from causing the fed funds rate to drop below 1.5 percent—the target it set when it announced its IOER plan. To repeat Ben Bernanke’s words once again, “by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did (Bernanke, 2015)."12
But interest on reserves could not discourage banks from placing newly-created reserves into the fed funds market without discouraging them from supplying any funds to that market: if a dollar of reserves that landed in a bank’s Fed account as a result of the Fed’s post-Lehman emergency lending earned more sitting in that account than it could earn if lent to another bank overnight, the same was true of a dollar of reserves held beforehand. Consequently, as the next chart shows, IOER served, not only to keep fresh reserves from lowering the fed funds rate, but to dramatically reduce the total volume of lending on the fed funds market: whereas financial institutions lent over $200 billion on the fed funds market during the last quarter of 2007, by the end of 2012 that figure has fallen to just $60 billion (Afonso, Entz, and LeSueur 2013).
As was to be expected, banks and bank holding companies (BHCs) that were eligible for IOER almost completely stopped lending overnight funds. Only the Federal Home Loan banks and other GSEs continued to lend as much as ever, for the sake of securing a share of banks' IOER earnings. The fed funds market thus ceased to function, as it had for decades, as banks' preferred and most reliable source of last-minute liquidity, having instead been transformed into a mere vehicle for bank-to-GSE interest-rate arbitrage.
VI. b. IOER vs. Perceived Counterparty Risk
Although some have attributed the decline in fed funds lending to a post-Lehman increase in perceived counterparty risk, that increase is no more capable of explaining the persistent decline in interbank lending than it is capable of explaining banks' persistent accumulation of excess reserves. While the TED spread—a popular measure of the perceived counterparty risk, equal to the difference between the interest rate on short- term interbank lending and the interest rate on Treasury securities—spiked at the time of Lehman's failure, it began to decline soon afterwards when the Fed decided to come to AIG's rescue, eventually falling to levels even lower than those that that prevailed before the crisis. Interbank lending, on the other hand, never recovered. The Fed's decision to pay interest on excess reserves therefore appears to have been the fundamental cause of the enduring post-Lehman decline in such lending.
The timing of the substantial rise in banks' excess reserves reinforces the last conclusion. Although banks accumulated excess reserves immediately following Lehman's failure, most of the increase occurred after the Fed began paying interest on reserves. Overall, the evidence suggests that, while an increased fear of counterparty risk accounted for banks' increased excess reserve holdings immediately following Lehman's failure, IOER was responsible for the subsequent more substantial and lasting increase in those holdings.13
Finally, the close relationship between the total volume of interbank lending and the opportunity cost of reserves holding, as measured by the difference between the interbank lending rates and the IOER rate, also supports the view that IOER drove the decline in interbank lending. Although the relationship is similar for all banks, it is clearest for foreign banks which, as we've seen, were especially tempted to accumulate excess reserves. Particularly striking is the almost exact coincidence of the precipitous decline in the opportunity cost of reserves coinciding with the introduction of IOER and an equally precipitous, initial decline in interbank loans.
VI. c. From Lender to Borrower of First Resort
The collapse of interbank lending created a further motive, beyond the return on reserves itself, for banks to accumulate excess reserves, as banks that once routinely relied on overnight unsecured loans to meet their liquidity needs discovered that, owing to the substantial decline in the availability of fed funds, doing so was no longer prudent. Because that decline at first caught many banks by surprise, its immediate effect was a sharp spike, on October 7, 2008, in the fed funds rate, which rose to 2.97 percent, or almost twice the Fed’s target at the time. Banks adapted by raising their excess reserve holdings so as to have sufficient precautionary reserves to cover those reserve needs that they had previously met by borrowing federal funds.
As Gara Afonso, Anna Kovner, and Antoinette Schoar (2010, p. 1) point out, until these changes came about, the fed funds market had long served as “the most immediate source of liquidity for regulated banks in the U.S.” Consequently any disruption of that market could “lead to inadequate allocation of capital and lack of risk sharing between banks.” In extreme cases, they add, it might “even trigger bank runs.” By paying IOER at above-market rates, the Fed, which is supposed to serve as a lender of last resort, unwittingly became both a borrower of first resort and the agent of destruction of banks’ traditional, first-resort source of emergency funds.
VII. IOER and Retail Bank Lending
VII. a. Lending Before and Since the Crisis
Between the week just before the Fed began paying interest on bank reserves, when it reached its pre-crisis peak, and the third week of March 2009, when it reached its post-crisis nadir, overall U.S. commercial bank lending declined from over $7.25 trillion to about $6.5 trillion—a decline of $1.25 trillion. Although reduced real estate lending accounted for the greatest part of this decline, other kinds of lending, including business lending, also fell sharply.
Although lending has recovered to a considerable extent since the crisis, at least relative to its pre-subprime boom trend, this recovery was painfully slow. Furthermore it masks an enduring and substantial post-crisis decline in the ratio of overall bank lending (“loans and leases”) to total bank deposits. Whereas total bank lending tended to match total bank deposits in the years leading to the crisis, since then, and specifically since IOER was introduced, it has declined to about 80 percent of deposits. Over that same period, bank reserves, as a percentage of total bank deposits, have increased from trivial levels to roughly 20 percent of bank deposits. In short, as a matter of simple balance- sheet arithmetic, the rise in banks’ holdings of (mainly) excess reserves has gone hand-in- hand with a corresponding decline in bank lending.
VII. b. The Direct Influence of IOER on Bank Lending
But does this correspondence mean that IOER was actually responsible for the decline in retail bank lending as a share of bank deposits? Many insist that IOER rates have been too low, compared to the rates on commercial bank loans, to have had more than a minor influence on bank lending. For example, Ben Bernanke and Donald Kohn (2016) observe that, during the long interval when the IOER rate stood at 25 basis points, “the only potential loans that would have been affected by the Fed’s payment of interest [on reserves] are those with risk-adjusted short-term returns between precisely zero and one-quarter percent.”
That view is, however, mistaken, on both empirical and theoretical grounds.
First of all, as we've seen, the growth in banks' excess reserve holdings was not an inevitable response to growth in the Fed's balance sheet: banks are always materially capable of reducing their excess reserve holdings, collectively as well as individually, either by making loans or by buying securities. It follows that the existence of substantial excess reserve balances is ipso-facto proof that the banks that acquired those reserves considered them more desirable than any other assets they might have acquired.
Standard microeconomic theory suggests, furthermore, that in equilibrium all of a banks' various assets should have, not the same marginal return, but the same marginal net return. Consequently, in theory at least, for any bank that holds excess reserves, the marginal net return on lending must not be any greater than the marginal return on such reserves. That means in turn that, if the return on reserves goes up, total bank lending must decline enough to once again make the marginal net return on loans the same as the return on reserves. To put this another way, although reduced short-term lending, and interbank lending especially, may be the first and most obvious consequence of an increase in bank reserves' relative yield, the eventual consequences will also include some reduction in longer-term bank lending.
Can this theory account for the apparent decline in lending as a share of deposits? It can, provided one understands, first of all, that not all banks enjoy equally high gross returns on lending. That fact is at least roughly reflected in different banks' net interest margins: the difference between the interest they earn and the interest they pay on bank deposits, expressed as a percentage of bank assets. Because bank deposit rates have themselves been extremely low since the crisis, and are in many cases at zero, banks' net interest margins supply a rough indication of their gross interest returns; and those margins have in fact been considerably lower for the largest U.S. banks, and lower still for foreign banks, than they have been for U.S. commercial banks as a whole. Whereas the net interest margin for all U.S. commercial banks has steadily declined from not quite 4 percent in early 2010 to just over 3 percent in 2017, the margin for banks in New York, which is home to the very largest banks, has been around 2 percent for most of that same period, while that for foreign banks generally has generally been less than 1.5 percent.
And it is, as we've seen, the very large domestic banks, as well as foreign bank branches, that have been holding most of the outstanding excess reserves.
Even 150 basis points is many times 25 basis points. But that's still not the right comparison, because there are substantial non-interest expenses involved in making loans, whereas the only non-interest expense of holding Fed balances consists of FDIC premiums assessed against a bank's total assets—and even that cost does not apply to most foreign bank branches. ECB area bank operating expenses, for example, are equal to about 60 percent of their interest income. And because borrowers sometimes default, and banks must make allowances for such defaults, loan loss provisions further reduce the net return on bank loans (Noizet 2016). As the next chart shows, those provisions reached a peak of 3.7 percent of total bank assets at the beginning of 2010, from which they've gradually fallen to their present level of 1.29 percent. Taking such losses as well as other costs of lending into account, it's no longer at all difficult to understand how a modest IOER rate might have made holding excess reserves seem more lucrative than granting a loan at a considerably higher non-risk-adjusted rate.
Nor is that all. Banks' net interest margins are a measure of the return on their entire loan portfolios. But allowing that the demand schedule for bank loans is downward-sloping, the return on a banks' marginal loan is necessarily lower than that on its loan portfolio as a whole; and it's this marginal return, net of both the interest and the non-interest expense associated with the marginal loan, that is supposed, in equilibrium, to be no higher than the bank's net marginal return on other assets, including any excess reserves it holds. Consequently, the mere existence of a positive difference between a banks' net interest margin and the IOER rate, even after allowing for the noninterest cost of loans, is perfectly consistent with the theory that banks' have found it more profitable to accumulate excess reserves than to part with those reserves by lending more.
The diagram below illustrates the last point. In it, the blue line represents the downward-sloping marginal revenue schedule for loans confronting the banking system, while the horizontal grey line represents the IOER rate, here assumed to be 100 basis points. For simplicity, I ignore banks' noninterest expenses altogether, while assuming that the Fed adjusts the total stock of reserves so as to keep total bank deposits constant.
In that case, assuming that they have $10 trillion in deposits at their disposal, the banks will collectively lend $8 trillion, while maintaining $2 trillion in excess reserves. But although the net return on the marginal loan is the same as the IOER rate, the banking system net interest margin, represented here by the orange line, will necessarily be higher than the IOER rate. Reducing the IOER rate to zero, on the other hand, encourages banks to lend 100 percent of their deposits, instead of holding any excess reserves.14
VII. c. Excess Reserves and Bank Lending in Japan
Some authorities doubt that IOER accounts for U.S. banks’ exceptional demand for excess reserves, and the associated decline in bank lending, because the same phenomena have occurred in other countries, and most notably in Japan, and did so even when banks’ reserve balances in those places bore no interest. As Kazua Ogawa (2005, p. 1) observes, “Japanese banks have chronically held excess reserves since the late 90’s,” with excess reserves tending, as in the U.S. since October 2008, to rise pari passu with the Bank of Japan’s additions to the total reserve stock.
However, Kazua also observes that Japan is no exception to the rule that “reserve supply does not necessarily automatically create a demand for reserves,” and that Japan’s banks, no less than U.S. banks, “have their own motives for excess reserves.” The motives have, moreover, been more-or-less the same in both cases.
U.S. banks, as we’ve seen, accumulated excess reserves because the positive return on those reserves was greater than the still-positive return on wholesale as well as some retail loans. Japanese banks, in contrast, began hoarding reserves long before the Bank of Japan began paying interest on reserves a month after the Fed’s having done so, in November 2008.
But as the U.S. case itself demonstrates, what matters isn’t the absolute IOER rate, but how that compares to rates on alternative uses of bank funds. In Japan before November 2008, although the IOER rate was zero, the overnight uncollateralized call rate—Japan’s equivalent to the fed funds rate—had itself fallen to zero, making reserves and call loans very close substitutes despite the fact that reserves bore no interest. The fact that Japanese depositors became increasingly leery of bank failures in the 90s finally tipped the scale in favor of reserves, as Japanese banks gained a further incentive to bolster their precautionary balances.
As can be seen in the pair of charts below, reproduced from Bowman, Gagnon, and Leahy (2010, p. 32), so long as the Bank of Japan paid no interest on banks’ reserve balances, Japanese banks accumulated excess reserves only after March 2001, when the Bank of Japan, in initiating its Quantitative Easing Program, allowed the call rate itself to fall to zero. When the BOJ ended that program five years later, while also increasing its lending rate, the call rate again rose above zero, causing Japan's banks to reduce their excess reserve balances. Finally, in November 2008, by beginning another round of Quantitative Easing, and reducing its lending rate to 30 basis points, the Bank of Japan brought the call rate back down 10 basis points, while simultaneously beginning to pay banks 10 basis points on their reserve balances. Consequently, Japanese banks once again began accumulating excess reserves.15
In short, like the Fed after October 2008, the Bank of Japan saw to it, intentionally or not, that Japanese banks' excess reserve balances rose and fell in lockstep with changes in the size of its balance sheet, which they would not have done had it maintained a positive spread between the call rate and the rate it paid on excess reserves. According to Ogawa's estimates, had Japan's call rate been 25 basis points rather than zero after 2000, even with no improvement in Japanese banks' perceived financial health, banks' subsequent demand for excess reserves might have been reduced by as much as 70 percent!
Thanks to the Bank of Japan's strategy, and in agreement with our own understanding that the influence of IOER on bank lending will be greatest where bank net interest margins are lowest, Japan's Quantitative Easing programs, instead of resulting in more lending by Japanese banks, had just the opposite effect, as seen in the next chart:
While it doesn't contradict the claim that IOER can be a crucial determinant of banks' willingness to accumulate excess reserves, Japan's experience does cast doubt on the suggestion that a U.S. IOER rate of zero would have sufficed after 2008 to have kept banks there from hoarding excess reserves. Whether it would have depends on whether other U.S. short-term rates, and the effective fed funds rate in particular, would have remained above zero. If not, nothing short of a negative IOER rate would have served to preserve a positive opportunity cost of reserve holding. Even so, a zero IOER rate would have supplied less of an inducement for reserve hoarding than a positive one. More importantly, as we shall see, Fed officials themselves were convinced that, had they returned the U.S. IOER rate to zero, the effective fed funds rate, despite falling further, would nevertheless have remained positive.
VII. d. IOER, Liquidity, and Bank Lending
Besides directly reducing bank lending by encouraging banks—and large U.S. banks and U.S. branches of foreign banks especially—to prefer, at the margin, acquiring excess reserves to making bank loans, IOER has also reduced it indirectly, by depriving those (mainly smaller) banks that have not been so inclined to accumulate excess reserves of their traditional means of covering themselves against the risk of short-run reserve shortages that additional lending entails. As the late Ronald McKinnon observed in a 2011 Wall Street Journal Op-Ed,