In late 2008, The Federal Reserve did something that was not so widely noticed: It started to pay interest on excess reserves, effectively paying banks not to lend.
Excess reserves are cash funds held by banks over and above the Federal Reserve’s requirements. They have grown dramatically since the financial crisis. Holding excess reserves is now much more attractive to banks because the cost of doing so is lower now that the Federal Reserve pays interest on those reserves. The fact that banks are holding excess reserves in response to the risks and interest rates that they face suggests that the reserves are not likely to cause large, unexpected increases in bank loan portfolios. However, it is not clear what banks are likely to do in the future when the perceived conditions change.
In other words, The Fed is trying to control the price and quantity of risk.
Excess reserves have actually declined slightly since 2015 when the article was written. But the question remains as to why financial institutions are continuing to park money at The Fed. And why The Fed is encouraging it.
Loan and lease growth YoY is slower following The Great Recession than at any time since 1975.
Part of the reason of the desire of commercial banks to park money at The Fed rather than lend it out is 1) risk (and the price of risk) and 2) compliance costs. The Dodd-Frank legislation and Elizabeth Warren’s Consumer Financial Protection Bureau have greatly increased compliance costs leading some financial institutions to avoid said costs and collect interest from The Fed instead.
What happens if the economy booms? A simple answer would be for The Fed to take away the excess reserve punch bowl. But bank lending has become so regulated (CFPB, OCC, Fed, FDIC, SEC, etc) that financial instutions may decide to continue the escape valve from actual lending.
I call excess reserves and the interest paid by The Fed to FI’s that DON’T lend … Ben and Janet’s Famous Chili recipe. If the economy does boom, I am afraid of what will happen.