Excess Reserves Are Not Free Reserves

 | Dec 20, 2011 | 4:00 PM EST  | Comments
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Following the 2008 economic crisis in the U.S., the Federal Reserve began to pay interest to banks for holding reserves at the Fed, the remuneration rate, and it was set at 25 basis points.

This is just above the Fed Funds target rate of 0 basis points to 25 basis points. In reality, the difference between these two rates has averaged just a few basis points during the past few years. The Fed Funds rate is the rate at which the banks can borrow from each other rather than directly from the Fed. The remuneration rate is the rate the Fed pays the banks for depositing funds with the Fed. By using this system, banks can supply overnight reserve capital to each other without having to borrow directly from the Fed at the much higher discount rate of 75 basis points 125 basis points.

By utilizing this system, the Federal Reserve has allowed banks to access credit from each other -- rather than from the Fed -- with the cost and return between the two being so low that they essentially negate each other.

The capital that the banks deposit at the Fed is referred to as "excess reserves". This is a deceptive name because the Fed made available the majority of these reserves to the banks, swapping them for illiquid loans, principally mortgage debt. This process is called a "repo" or repurchase agreement. That means that the Fed "buys" the illiquid loan from the bank, and, in turn, the bank agrees to "buy" the loan back from the Fed in the future.

When the bank takes the proceeds from the repurchase agreement and deposits them at the Fed, a reverse repurchase agreement has been initiated.

Banks enter into such agreements so that their risk level is reduced. In essence, the Fed agrees to accept the risk of holding the illiquid mortgage paper. The bank does not have to set aside capital reserves against the cash loan proceeds it took as a swap for the mortgage, and it is now in a position to make more loans.

At some point both the repurchase agreement and the reverse repurchase agreement must be unwound. That point is usually when the illiquid mortgage asset matures by way of the underlying physical asset being sold, by default/foreclosure or by refinancing the mortgage.

When one of these events occurs, the excess reserves no longer have any collateral. So, the bank must return the loan it took from the Fed. Then, the Fed returns to the bank whatever the proceeds were from the maturing mortgage. If these proceeds were greater than the loan that the bank took from the Fed against the mortgage, the bank books a profit. If the proceeds are less, however, the bank takes a loss and must make up for the difference in payment to the Fed in some other way.

Because of the volatility in the value of the illiquid mortgage paper and the physical collateral of the past few years, which has affected all of the money centers, repurchase and reverse repurchase agreements have been a wonderful way for the banks and the Federal Reserve to allow the illiquid mortgage paper to roll off the books of the banks with as little interference by the banks or the Federal Reserve.

Now, however, a growing number of people are advocating that the banks use the proceeds received from the Fed in swap for the illiquid mortgage debt to make new loans in order to drive economic activity.

The problem with this scenario is that if the illiquid mortgages mature, the bank will now have to come up with cash, a capital call, to pay the Fed back and to not be declared insolvent.

The cost of raising capital in this situation is prohibitively expensive with the least costly approach is for the banks to use the Fed discount window at 75 basis points to 125 basis points vs. around 10 basis points by allowing excess reserves to absorb the roll off.

An abrupt increase in these costs driven by a surge in maturing illiquid mortgages could even render the banks insolvent again and require another 2008 TARP / QE-type bailout.

The bottom line is that there is no free lunch. The system of using banks' excess reserves parked at the Fed for the purpose of absorbing maturing illiquid mortgages should not be tampered with, and those reserves should not be redeployed into the economy or capital markets some other way.

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