Bernanke’s Big Bank Subsidy

Until October 2008 bank reserves held by the Federal Reserve Bank (Fed) paid no interest. Banks are required to keep some of their deposits on reserve, but it was costly to keep excess reserves because they earned no interest.

For a bit more than a year now the Fed has been paying interest on bank reserves it holds. This is a new policy and amounts to a windfall for banks. The policy was enacted because when the Fed bought up all those toxic assets (also a new policy; prior to the mortgage meltdown the Fed almost exclusively purchased only securities issued by the US Treasury), it paid for them by creating new reserves. If banks lent out those reserves, which they would have an incentive to do because reserves didn’t earn any interest, the money supply would skyrocket and inflation would result. The Fed has kept banks from lending by paying interest on the reserves.

The Fed is keeping short term interest rates low, and that includes the rate they are paying on reserves, which is currently 0.25%. The Fed currently holds about $1.1 trillion in excess reserves, so even at this low annual rate that would generate about $2.75 billion in risk-free interest income to banks.

That sounds like a lot of money to me, but the really big subsidies would kick in when the Fed starts raising interest rates as the economy recovers, to try to prevent inflation. An interest rate of 2% on those reserves — still a low rate by historical standards — would pay banks $22 billion a year.

While the Fed makes this decision, ultimately the money comes out of the US Treasury. Every year the Fed earns more on its holdings of government bonds than it spends, so returns the excess to the Treasury. The more it pays in interest, the less it returns to the Treasury, so the Treasury has to borrow that much more to meet its excessive budget.

Essentially, the Fed is using taxpayer money to subsidize banks in an attempt to offset potentially pernicious effects of its bailout. Banks benefit twice: once because the Fed took toxic assets off their hands; once because the Fed is now paying interest on the resulting reserves. Perhaps the worst aspect of this is that rather than penalize firms that took risks that went bad, they are being rewarded, which will only encourage more risky behavior in the future.

The Fed’s bank subsidy is an example of one bad policy designed to counteract the effects of another. If the Fed hadn’t bought those toxic assets it wouldn’t need to subsidize banks to keep them from lending. It’s easy to spend money when the money you’re spending is someone else’s.