How One Possible Fed Stimulus Measure Could Actually End Up Slamming Consumers

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As was widely discussed yesterday, Jon Hilsenrath of the WSJ noted that the Fed is considering three “unconventional” steps.    Among these options was lowering interest earned on excess reserves (IOER) from 0.25% to 0%.  

Hilsenrath noted: “A second step under consideration at the Fed, one getting mixed reviews internally, would reduce or eliminate a 0.25% interest rate the Fed currently is paying banks that keep cash on reserve with the central bank.

The 0.25% payment is greater than the 0.196% rate an investor can get on a two-year Treasury. Some officials believe the Fed shouldn’t reward banks for holding cash instead of making loans.

“I’m not especially pleased with the way that policy tool is working at the moment,” Charles Evans, president of the Federal Reserve Bank of Chicago, said in a recent interview. Mr. Rosengren said cutting that rate could give banks more incentive to lend and would further signal the Fed’s determination to get the economy going.

Other Fed officials believe that reducing the rate wouldn’t do much good because it is already so low, and might instead disturb short-term money markets.

Let’s summarize the current situation.  Banks are currently flushed with liquidity as lending opportunities are scarce and they are hesitant to devote incremental deposits to government backed securities with an already depressed yield curve environment.  So instead, they choose to leave deposits overnight at the Fed for 25bps.

Now here’s the misconception: this 25bps really isn’t free profit.  Banks pay FDIC insurance on deposits which eats into most/all of this amount.  Should the Fed lower IOER to zero, these deposits which were roughly break even for many banks would now be a loss.

The cause & effect of this would undoubtedly be banks adding in additional fees to deposit customers to cover this loss of revenue.  Bank NIM would get squeezed with the loss of interest income.  Overall net income would be affected less as an increase of fees would be seen below the line.

Would the loss of this 25bps change behavior among banks?  It’s difficult to say. Would they be willing to add duration by buying a 3yr treasury at 32bps to offset the loss of income?  More importantly, would this loss of 25bps accentuate the increasing opportunity cost of incremental loans?  My prediction would be little/no increase in loans, a small amount of additional securities purchases & with the lions share content to be held at the Fed for nothing at all.

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