The Bernanke Fed Plans to Give Large Banks Billion Dollar Annuities

What I once described as "Malpractice at the Bernanke Federal Reserve" has now turned into billion dollar annuities to the stock holders of the large banks.
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What I described as "Malpractice at the Bernanke Federal Reserve" has now turned into billion dollar annuities to the stock holders of the large banks. The Bernanke Fed began paying interest on reserves held by the banks in October 2008 when the financial crisis heightened after large financial firms went bankrupt or were bailed out. It was essential policy to safeguard the banking system with loans, but not with incentive payments to reduce their lending and increase their reserves at the expense of businesses and employment.

The excess reserves, reserves that banks are not required to keep, exploded: from $1.875 billion on September 1, 2008 to $1.191 trillion on February 2, 2011. The chart of excess reserves from the Federal Reserve is exploding while its chairman, Ben Bernanke, talks about plans to increase the interest on bank reserves.

Today in the middle of the Bernanke Fed's continuing purchase of $600 billion in Treasury securities -- its quantitative easing purchases, "QE2," which ends in June 2011 -- where do you think most of the $600 billion is going? Loans to businesses? Purchase of private sector income earning assets? No and No. Since September 2008 -- 25 months -- the Fed has pumped out an average of $49 billion a month. This monetary base of the country (currency, coin and bank reserves) is now $2.210 trillion. Over half (57 percent) of the $2.210 trillion sits in the banks as reserves drawing interest.

Now with inflation looming on the horizon and a need to finance huge governments deficits, interest rates will rise unless there is some event that temporarily makes investors rush to buy Treasury securities. What will the Fed do to prevent banks from moving their reserves into private sector assets, as banks make loans and buy other income earning assets. The money supply would spike and add strong fuel to inflation and higher interest rates.

To keep the money supply from ballooning Bernanke has advocated, and many others at the Fed probably agree, that more interest on reserves will be needed. As I previously stated, that is the wrong policy. It is long past time to raise the Fed's target interest rate target. The Fed's near zero interest rate policy causes many misallocations of resources. A higher Fed interest rate target would lower the monetary base as the Fed sells its securities. The interest paid to banks could be lowered and eventually eliminated making the banks invest in loans and other income earning assets that benefit the economy and employment.

Today the banks receive 0.25 percent interest on their reserves (plus deposits of their reserves that are held for a designated period, The Term Deposits Facility). That cost to the taxpayers was $2.7 billion in 2010. If the interest rate paid to banks increases to 1 percent and reserves are at the present level, the cost to the taxpayers would be around 4 times that amount, $10.8 billion a year.

In 2003 I testified in Congress against the payment of interest on bank reserves. I had already helped House Banking Committee Chairman Henry Reuss write a bill that became a law (1980 Monetary Control Act) that allowed the Fed to pay interest on special required reserves in times of emergency. The Fed was evidently not interested in bringing this up at the hearings (although they sent an excellent official, Governor and future Vice Chairman Donald Kohn, to present their case) since they wanted carte blanche on the taxpayers' money to pay banks interest on reserves.

The average interest rate over a prior thirty year period used for Fed loans to banks was 5 percent. At today's level of reserves that would cost the taxpayers $60 billion a year. Based on the calculations given below, that level of interest payments would have a present value primarily for bank stockholders of $1.08 trillion.

I did not predict the astounding level of excess reserves now being rewarded with taxpayer money when I said:

Consider the effects of the proposed payment of interest on reserves. The Fed held $9.3 billion of the private banks' required reserves on February 5, 2003. I assume that the Fed will use the Federal funds rate or something close to it for these interest payments. (...) The average Federal funds rate in the 30 years from 1970 to 2000 was 7.7 percent. To avoid the complaint that those thirty years were somehow an anomaly and the current period of low interest rates will be the norm I settle for a long term average Federal funds rate of 5 percent.

That rate for a guaranteed perpetual government subsidy will certainly increase the size of reserves at the Fed. The reserves at the Fed could rise to their level in 1990 of over $35 billion. I use $20 billion as a conservative estimate of the required reserves parked at the Fed. At 5 percent that would yield $1 billion a year. Assuming a 6 percent rate of discount this guaranteed government income stream would have a value of $16.7 billion.
"The $16.7 billion asset given by the government to the banks can have positive welfare effects if its income stream is transferred to depositors as interest on their deposits, as some economists have theorized assuming the banking industry is a competitive industry. This is the wrong model. I would be happy to explain this point using the example of parallel pricing the industry uses for its advertised prime rate. [I will present that explanation in a future blog.] The primary recipients of the $16.7 billion government guaranteed perpetual annuity will be the stockholders of large banks. They will receive very respectable capital gains.

(Testimony of Robert D. Auerbach Before the Subcommittee on Financial Institutions and Consumer Credit, The House of Representatives Committee on Financial Services Hearings on H.R. 758, the Business Checking Freedom Act, and H.R. 859, the Business Checking Freedom Act, March 5, 2003)

Members of both political parties supported the payment of interest on reserves. It became a law that was put into practice with a Fed announcement on October 6, 2008.

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