Why the Fed Pays Interest on Banks’ Reserves
The Federal Reserve is often called the “bankers’ bank.”
That’s because its 12 Reserve banks and their branches, located in major cities across the country, provide services to commercial banks that mirror the services banks offer their own customers. For instance, Reserve bank functions include lending money and distributing currency to banks.
But are commercial banks required to keep deposits with the Fed? And, if so, do they earn interest on those deposits?
About Reserve Requirements
Depository institutions including commercial banks, savings institutions and credit unions must meet statutory reserve requirements. The amount a bank must hold in reserves is based on its deposit liabilities.
Banks can either keep cash in their vaults or hold deposits with the Fed. Most banks today have accounts with their regional Reserve bank—not only to satisfy these requirements, but also for the payment services the Fed offers.
Interest as a Monetary Policy Tool
Reserve banks didn’t use to be able to pay interest on deposits. That changed with the Emergency Economic Stabilization Act of 2008.
In order to provide more liquidity to the banking system, the Fed needed to expand its balance sheet by buying Treasuries and mortgage-backed securities.
“The only way we could do that was to expand the reserve deposits the banks held with us,” said David Wheelock, St. Louis Fed group vice president and deputy director of research. “It was necessary to pay interest on those deposits in order to avoid excessive money growth solely as a result of the temporary injection of liquidity into the banking system during the financial crisis.”
Now, depository institutions receive interest on the minimum required reserve balances they hold with the Fed. They also earn interest on reserves held in excess of what’s required.
This chart shows how reserve amounts have grown dramatically post-2008.
The Fed is a place where banks “can park their money for periods until they find a good investment opportunity, a good lending opportunity,” Wheelock said.
(Some institutions keep deposits with the Fed but don’t receive interest—specifically, Fannie Mae and Freddie Mac and the Federal Home Loan banks.)
Interest Earned and the Federal Funds Rate
So, has the Federal Open Market Committee’s recent path of raising the federal funds rate target affected the interest rate that banks earn on deposits?
The short answer is yes.
Wheelock explained that, given the large volume of deposits held at Reserve banks, the Fed has needed to raise the interest rate it pays on reserves to get the fed funds rate to rise. Doing so increases the amount of interest the Fed pays out.
Over time, however, as the Fed takes steps to shrink its balance sheet, the amount of interest the Fed pays out should decline, he said.
This blog explains everyday economics, consumer topics and the Fed. It also spotlights the people and programs that make the St. Louis Fed central to America’s economy. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.