The Federal Reserve needs to be vigilant regarding increasing excess reserve levels, since it's not clear what banks will do when conditions change, according to
Banks' excess reserves have surged from $1.9 billion in August 2008 to $2.6 trillion in January 2015, partly as a result of it being more attractive, since the Fed is paying more interest than they would get from riskier investments.
Determining why banks have chosen to hold excess reserves rather than make more loans "has implications for monetary policy and the real economy, but it is elusive because the current economic environment is complex and still new," according to Cleveland Fed researchers Ben Craig and Matthew Koepke.
The financial crisis "altered the trade-off that banks make when calculating their desired levels of excess reserves. Banks now encounter an environment where holding reserves is much more attractive because the cost of holding them-in the form of foregone interest-is significantly lower than it was before the crisis. The Federal Reserve has embarked on several policies designed to pump large amounts of reserves into the banking system, fostering conditions in which it is both easier and more attractive for banks to hold huge amounts of excess reserves," the researchers say.
Since December 2008, the Fed has paid 25 basis points interest on all reserves, as opposed to the federal funds market, which was a favorite of banks before the crises. The federal funds market has paid "between 7 and 20 basis points since the crisis."
Other investments have also lagged the 25 basis points the Fed is paying on reserves.
"A quick comparison of the Fed's balance sheet and the amount of excess reserves shows an almost one-to-one correspondence between the two," the researchers write.
But the problem comes with trying to predict how banks will react "in the presence of the expanded reserves," the researchers say. "Unfortunately, understanding this behavior is what matters for deciding on an appropriate policy for excess reserves."
It is unlikely, they posit, that there will be "large, unexpected increases" in bank loan portfolios, but "it is not clear what banks are likely to do in the future when the perceived conditions change or which conditions are likely to bring about a massive change in their use of excess reserves. Recent history is not much help in determining the answer to this question because no balances this big have been seen in recent times," the researchers write.
"So the Federal Reserve has no easy policy choices, particularly in the absence of a large body of accepted theory on how banks can be expected to handle their oceans of cash under changing conditions," according to Craig and Koepke. "Perhaps the best thing to do is what they are doing, that is, to adopt an extremely watchful stance and wait."
