Interest on excess reserves

What Is Interest on Excess Reserves?

Interest on excess reserves (IOER) refers to the interest rate paid by a central bank to depository institutions on funds they hold in their accounts at the central bank that exceed their reserve requirements. This payment mechanism falls under the broader umbrella of monetary policy, serving as a crucial tool for central banks to influence short-term interest rates and manage the overall money supply within the economy. When banks hold more reserves than legally required, these additional funds are considered "excess reserves." The interest paid on these balances incentivizes banks to either lend or hold these funds at the central bank, thereby affecting market liquidity.

History and Origin

The authority for the Federal Reserve to pay interest on reserves was granted by the Financial Services Regulatory Relief Act of 2006, initially set to become effective in October 2011. However, the effective date was accelerated to October 1, 2008, by the Emergency Economic Stabilization Act of 2008, a critical period during the global financial crisis.¹⁶, ¹⁷ On October 6, 2008, the Federal Reserve Board announced it would begin paying interest on both required reserve balances and excess reserve balances.¹⁵ This decision marked a significant shift in how the Federal Reserve conducted its monetary policy. Previously, banks earned no interest on excess reserves, which meant that any funds held beyond requirements represented an opportunity cost in terms of foregone lending income.¹⁴ The introduction of interest on excess reserves provided the Federal Reserve with an additional lever to manage financial conditions, particularly during times of large reserve balances resulting from actions like quantitative easing.¹³ Since July 29, 2021, the interest rate on excess reserves (IOER) and the interest rate on required reserves (IORR) were replaced with a single rate, the interest rate on reserve balances (IORB).¹²

Key Takeaways

• Interest on excess reserves (IOER) is a monetary policy tool used by central banks, such as the Federal Reserve, to influence the money supply and short-term interest rates.
• It is paid on funds that depository institutions hold at the central bank beyond their legally mandated reserve requirements.
• The Federal Reserve began paying interest on excess reserves in October 2008, during the global financial crisis, to provide greater control over the federal funds rate.
• As of July 2021, the IOER and Interest on Required Reserves (IORR) were unified into a single rate called the Interest on Reserve Balances (IORB) rate.¹¹
• This tool helps maintain financial stability and allows central banks to manage liquidity effectively in the banking system.

Formula and Calculation

The calculation of interest on excess reserves, now subsumed under the Interest on Reserve Balances (IORB), is generally straightforward. Prior to July 29, 2021, the interest on excess reserves (IOER) was calculated by multiplying the IOER rate in effect each day of the maintenance period by the institution's excess balances that day.¹⁰

Currently, the interest on reserve balances is calculated based on the end-of-day balance maintained by a depository institution multiplied by the IORB rate in effect for that day.

The daily interest calculation for reserve balances is:

where:

• End-of-Day Balance refers to the total funds a depository institution holds at the Federal Reserve at the close of a business day.
• IORB Rate is the annual interest rate on reserve balances set by the Board of Governors of the Federal Reserve System, expressed as a decimal.

At the end of a maintenance period, the total interest for each day of the period is summed up and paid to the institution.⁹

Interpreting the Interest on Excess Reserves

The interest on excess reserves (or the unified IORB rate) is a key indicator of the central bank's stance on monetary policy. A higher rate of interest on excess reserves encourages banks to hold more funds at the central bank, reducing their incentive to lend these funds in the interbank market. This can put upward pressure on the federal funds rate, the target rate for central bank policy. Conversely, a lower interest on excess reserves rate reduces the incentive for banks to hold funds at the central bank, potentially encouraging them to lend more to other banks or consumers, thereby increasing liquidity in the financial system. The rate acts as a floor for overnight interbank lending rates because no bank would lend money at a rate lower than what it could earn by simply holding those funds at the central bank.⁸

Hypothetical Example

Consider a scenario where a commercial bank, "Bank A," has excess reserves of $100 million at the Federal Reserve. If the Federal Reserve sets the Interest on Reserve Balances (IORB) rate at 5%, Bank A would earn interest on these excess funds.

For a single day, the interest earned would be:

Daily Interest = $100,000,000 × (0.05 / 365) = $13,698.63 (approximately)

Over a year, if the rate remains constant and Bank A maintains this level of excess reserves, the annual interest earned would be $5,000,000. This example illustrates how interest on excess reserves provides a risk-free return for banks holding funds at the central bank, influencing their decision-making regarding lending and overall balance sheet management.

Practical Applications

Interest on excess reserves is a vital tool for central banks in implementing monetary policy. Its practical applications include:

• Influencing Short-Term Rates: By adjusting the interest rate on excess reserves, the central bank can steer the effective federal funds rate within its target range, as banks are unlikely to lend funds in the federal funds market at a rate significantly below what they can earn risk-free from the central bank.
  ⁷* Managing Liquidity: During periods of abundant liquidity in the banking system, such as those following large-scale asset purchases (quantitative easing), interest on excess reserves helps to absorb some of that liquidity and maintain control over short-term rates.
• Supporting Financial Stability: This tool allows the central bank to provide the necessary liquidity to the financial system without losing control over its policy rate, contributing to overall financial stability.
  ⁶* International Comparison: Many major central banks globally employ similar policy rates on reserves, suggesting its effectiveness as a standard monetary policy instrument. ⁵For current and historical rates, resources like the Federal Reserve Economic Data (FRED) from the Federal Reserve Bank of St. Louis provide comprehensive information.
  ⁴

Limitations and Criticisms

Despite its utility, interest on excess reserves has faced certain criticisms and presents limitations. One common critique, particularly during periods of low interest rates and large reserve balances, is that the payments to banks could be perceived as a "giveaway" or subsidy to financial institutions. ³Critics argue that this policy might reduce the incentive for banks to lend to the real economy, especially if the interest on excess reserves rate is attractive enough compared to the risks associated with private lending.

Furthermore, some argue that the policy may complicate the effective transmission of monetary policy, particularly in a "floor system" where banks hold ample reserves. The Cato Institute, for instance, has raised concerns about the wisdom of making interest on excess reserves a permanent part of the Federal Reserve's toolkit, citing potential "complications and risks" that extend beyond traditional central banking functions. ²The interaction with other market rates, and whether the interest on excess reserves truly sets a firm floor for all short-term rates, can also be a subject of debate.

Interest on Excess Reserves vs. Federal Funds Rate

Interest on excess reserves (IOER, now part of IORB) and the federal funds rate are distinct yet closely related concepts in the realm of central bank policy, often leading to confusion.

While the central bank directly sets the interest on excess reserves, the federal funds rate is a market rate that the central bank targets. The interest on excess reserves serves as a key tool for the central bank to guide the federal funds rate toward its desired target, as banks have little incentive to lend funds at a rate lower than what they can earn risk-free by keeping them at the central bank.
¹

FAQs

Why does the Federal Reserve pay interest on excess reserves?

The Federal Reserve began paying interest on excess reserves to gain greater control over the federal funds rate and to manage the large volume of reserves in the banking system, particularly after periods of quantitative easing. It provides a floor for short-term interbank lending rates.

What is the difference between interest on excess reserves and required reserves?

Historically, interest on excess reserves (IOER) was paid on funds held by banks at the Federal Reserve beyond their mandated reserve requirements. Interest on required reserves (IORR) was paid on the portion of reserves that banks were legally obligated to hold. Since July 2021, these two rates were combined into a single Interest on Reserve Balances (IORB) rate, meaning all eligible reserve balances earn this rate.

How does interest on excess reserves affect the economy?

By influencing the opportunity cost of holding reserves, interest on excess reserves affects banks' lending decisions and, consequently, the overall money supply and short-term interest rates in the economy. This, in turn, can influence borrowing costs for businesses and consumers, impacting economic activity and inflation.