Saturday, 14 August 2010

Interest on reserves discourages lending?

The Atlanta Fed wonders whether interest payments by the Fed on reserves discourages bank lending (the word “bank” is used here to refer to private sector or “commercial” banks.)

The obvious answer is “yes”. But longer term, and especially if that interest rate rises, the answer is no. Reasons are thus.

Where a bank lends $X, the money mostly ends up in accounts in other banks. The first bank then has to transfer $X of reserves to those other banks, and operation done in the Fed’s books. Thus the first bank loses interest on reserves. And if interest is earned on reserves, then the latter are a disincentive to lend.

But the private sector banking system AS A WHOLE does not lose interest. This means that there is potential profit for this system to act “as a whole”: that is get together and by-pass the Fed.

And members of most professions are normally quick to think up mutually beneficial arrangements (monopolies, cartels, etc), which involve members of the profession acting “as a whole” . Or as Adam Smith said , “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

So how would a “Fed bypassing” system work? One option would be an agreement (formal or informal) by banks just to ignore the Fed and adjust numbers in their own books to reflect which bank owed what to which other bank. This agreement could include a clause saying that any bank asking the Fed to do the relevant book-keeping would be punished by other banks: i.e. if one bank asked the Fed to debit the accounts (in the Fed’s books) of other banks, the latter banks would effectively say to the first bank “OK, at the next suitable opportunity, we’ll ask the Fed to debit your account”. And if a “next suitable opportunity” does not arise within some specified, time, “we’ll invoice you for the interest we’ve lost”.

It is possible that an agreement along the above lines would be illegal, but that is of limited relevance: the law has never been a big obstacle for monopolies, cartels and so on. And the banking industry is not just any old cartel: it’s a super efficient cartel. In the words of Congressman Dick Durbin referring to banks and Congress respectively, “Frankly they own the place”.

Another factor which renders interest on reserves an ineffective method of discouraging bank lending is that banks are well aware that this interest is probably a temporary measure, because we are in unusual economic circumstances. If a bank sees a lending opportunity which because of interest on reserves is not profitable now, but will become profitable when this interest vanishes, the bank will go ahead with the loan: most businesses are happy with a small loss for a short period if it results in increased market share in the long run.

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