Interest On Reserves, Part III

Ben Bernanke, financial crisis, interest on reserves, Lehman Brothers, TED Spread
Emily Levin, harpist:

HarpistWhy do I keep harping on interest on reserves?  Because, IMHO, the Fed's decision to start paying interest on reserves contributed at least as much as the failure of Lehman Brothers or any previous event did to the liquidity crunch of 2008:Q4, which led to a  deepening of the recession that had begun in December 2007.

That the liquidity crunch marked a turning point in the crisis is itself generally accepted.  Bernanke himself (The Courage to Act, pp. 399ff.) thinks so,  comparing the crunch to the monetary collapse of the early 1930s, while stating that the chief difference between them is that the more recent one involved, not a withdrawal of retail funding by panicking depositors, but the "freezing up" of short-term, wholesale bank funding.  Between late 2006 and late 2008, Bernanke observes, such funding fell from $5.6 trillion to $4.5 trillion (p. 403).  That banks altogether ceased lending to one another was, he notes, especially significant (p. 405).  The decline in lending on the federal funds market alone accounted for about one-eighth of the overall decline in wholesale funding.

For Bernanke, the collapse of interbank lending was proof of a general loss of confidence in the banking system following Lehman Bothers' failure.  That same loss of confidence was still more apparent in the pronounced post-Lehman increase in the TED spread:

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis. Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2-1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March (corresponding to the Bear Stearns rescue), declined modestly over the summer, then showed up when Lehman failed, topping out at more than 4-1/2 percentage points in mid-October 2008 (pp. 404-5).

These developments, Bernanke continues, "had direct consequences for Main Street America. … During the last four months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost.” (406-7)

There you have it, straight from the horse's mouth: the fourth-quarter, 2008 contraction in wholesale funding, as reflected in the collapse of interbank lending, led to the loss of at least 6.2 million jobs.

But was the collapse of interbank lending really evidence of a panic, brought on by Lehman's bankruptcy?  The timing of that collapse, as indicated in the following graph, tells a much different story.

Interbank Loans All Commercial Banks

The first of the three vertical lines is for September 15, 2008, when Lehman went belly-up.  Interbank lending on the next reporting date — September 17th —  was actually up from the previous week.  Thereafter it declined a bit, and then rose some.  But these variations weren't all that unusual.  As for the TED spread, although it rose sharply after Lehman's failure, the rise reflected, not an actual increase in the effective federal funds rate (as the "panic" scenario would suggest), but the fact that that rate, though it actually declined rapidly, did not do so quite as rapidly as the Treasury Bill rate did:

TED Spread

OK, now on to those other vertical lines.  They show the dates on which banks first began receiving interest payments on their excess reserves.  There are two lines because back then two different sets of banks had different "reserve maintenance periods," and therefore started getting paid at different dates.  (The maintenance periods have since been made uniform.) Those (mostly smaller) banks with one-week reserve maintenance periods began earning interest on October 15th; the rest, with two-week maintenance periods, started getting paid on October 22nd.  The collapse in interbank payments volume coincides with the latter date.  Notice also that the collapse continues after the TED spread has returned to a level not so different from its levels before Lehman failed.

If you still aren't convinced that IOR was the main factor behind the collapse in interbank lending, perhaps some more graphs will help.  The first shows the progress of interbank lending over a somewhat longer period, along with the 3-month Treasury Bill rate and (starting in October 2008) the interest rate on excess reserves:

IOR and Interbank Lending

To understand this graph, think of the banks' opportunity cost of holding excess reserves as being equal to the difference between the Treasury Bill rate and the rate of interest on excess reserves.   Prior to October 15th, 2008, the opportunity cost, being simply equal to the Treasury Bill rate itself, is necessarily positive.  But when IOR is first introduced, it becomes practically zero; and shortly thereafter it becomes, and remains, negative.  Mere inspection of the chart should suffice to show that the volume of interbank lending tends to vary directly with this opportunity cost.

Once the interest rate on excess reserves is fixed at 25 basis points after mid-December 2008, things get simpler, as the volume of interbank lending varies directly with the Treasury Bill rate.  Here is a chart showing that period, with the opportunity cost itself (that is, the Treasury Bill rate minus 25 basis points) plotted along with the volume of interbank lending:

Opportunity Cost

Now, it would be one thing if Bernanke were merely guilty of misunderstanding the cause of the decline in interbank lending, without having actually been responsible for that decline.  But Bernanke was responsible, as was the rest of the Fed gang that took part in the misguided decision to start rewarding banks for holding excess reserves in the middle of a financial crisis.

What's more, it is hard to see how Bernanke can insist that the Fed's decision to pay IOR had nothing to do with the drying-up of the federal funds market given the justification he himself offers for that decision earlier in his memoir, which bears quoting once again, this time with emphasis added:

 [W]e had been selling Treasury securities we owned to offset the effect of our lending on reserves… . But as our lending increased, that stopgap measure would at some point no longer be possible because we would run out of Treasuries to sell….The ability to pay interest on reserves…would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed (p. 325).

Yet when he turns to explain the causes of the collapse in interbank lending, just eighty pages after this passage, Bernanke never mentions interest on reserves.  Instead, he blames the collapse on panicking private-market lenders, while treating the Fed — and, by implication, himself — as a White Knight, galloping to the rescue.  "As the government’s policy response took effect," he writes, "the TED spread declined toward normal levels by mid-2009" (p. 405).  What rubbish.  We've already seen why the TED spread went up and then declined again.  And although interbank lending itself revived somewhat during the first half of 2009, it declined steadily thereafter, ultimately falling to lower levels than ever.

And the Fed's "policy response"?  According to Bernanke, it had "four main elements: lower interest rates to support the economy, emergency liquidity lending…and the stress-test disclosures of banks’ conditions” (409).  Let Kevin Dowd tell you about those idiotic stress tests.  As for "lower interest rates," they were proof, not that the Fed was taking desirable steps, but that it was failing to do so, for although the Fed did get around to reducing its federal funds rate target, its doing so was a mere charade: the equilibrium federal funds rate had long since fallen well below the Fed's target, and the subsequent moves merely amounted to a belated recognition of that fact, without making any other difference.  Finally, although the Fed's emergency lending aided the loans' immediate recipients, as well as their creditors, it contributed not a jot to overall liquidity, the very point of IOR having been — as Bernanke himself admits, and as I explained in my first post on this topic — to prevent it from doing so!

As the next chart shows, IOR, besides contributing to the collapse of interbank lending, also played an important part in the dramatic increase in the banking system reserve ratio.  The vertical lines represent the same three dates as those referred to in the very first chart.  Although the ratio did  rise considerably following Lehmans' failure, it rose even more dramatically — and, quite unlike the TED spread, never recovered again — after the Fed started paying interest on excess reserves:


To better understand what went on, here is another diagram, this one showing banks' choice of optimal reserve and liquid asset ratios as a function of the interest paid on bank reserves:


In the diagram, the vertical axis represents the interest rate on reserve balances, in basis points, while the horizontal axis represents the reserve-deposit ratio.  The picture shows two upward-sloping schedules.  The first is for reserve balances at the Fed, while the second is for liquid assets more generally, here meaning (for simplicity's sake) reserves plus T-bills.  The horizontal line shows the yield on T-bills at the time of implementation of IOR, here assumed to be a constant 20 basis points.  The two dots, finally, represent equilibrium ratios, the first (at the lower left) for before the crisis and IOR, the other for afterwards.  Note that, the high post-IOR ratio reflects, not just the interest-sensitivity of reserve demand, but that, with IOR set at 25 basis points, reserves dominate T-bills.  Thus, although the demand for excess reserves may not be all that interest sensitive so long as the administered interest rate on reserves is less than the rate earned by other liquid assets, that demand can jump considerably if that rate is set above rates on liquid and safe securities.

The last chart I'll trouble you with today tracks changes in total commercial bank reserves, interbank loans, Treasury and agency securities, and commercial and industrial loans, from mid-2006 through mid-2009, this time with a single vertical line only, for October 22, 2008, when IOR was in full effect:

Composition of Bank Assets

The chart shows clearly how the beginning of IOR coincided, not only with a substantial decline in interbank lending (green line), but in a leveling-off of other sorts of bank lending, which later becomes a pronounced decline.  For illustration's sake, the chart shows the course of C & I lending only; other sorts of bank lending fell off even more.

Don't get the wrong idea: I don't wish to suggest that IOR was responsible for the post-2008 decline in bank lending, apart from overnight lending to other banks.  There's little doubt that that decline mainly reflects the effects of both a declining demand for credit and much stricter regulation of bank lending, especially as Dodd-Frank and Basel III came into play, Nor do I believe that merely eliminating IOR, as opposed to either reducing the regulatory burdens on bank lending, or resorting to negative IOR (as some European central banks have done), or both, would have sufficed to encourage any substantial increase in bank balance sheets, and especially in bank lending, after 2009, when most estimates (including the Fed's own) have "natural" interest rates sliding into negative territory.  But as I noted in my first post in this series, when IOR was first introduced, natural rates were, according to these same estimates, still positive.  And one thing IOR certainly did do, both before 2009 and afterwards, was to allow banks, and some banks more than others, to treat trillions in new reserves created by the Fed starting in October 2008, not as an inducement to expand their balance sheets, but as a direct source of risk- and effort-free income. (Note, by the way, how, just before IOR was introduced, but after the Fed stopped sterilizing its  emergency loans, bank loans and security holdings did in fact increase along with reserves.)

Moreover, it's evident that the FOMC itself, rightly or wrongly, sees IOR as continuing to play a crucial part in limiting banks' willingness to expand credit.  Otherwise, how can one possibly understand that bodies' decision last month to raise the rate of IOR (and, with it, the upper bound of its federal funds rate target range) from 25 to 50 basis points?  That decision, recall, was aimed at making sure that bank credit expansion would not progress to the point of causing inflation to exceed the Fed's 2 percent target:

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

Bernanke's implementation and defense of IOR would be more than bad enough, were it not also for his particular determination to avoid repeating the mistakes the Fed made during the Great Depression.  "[M]ost of my colleagues and I were determined," he says, "not to repeat the blunder the Federal Reserve had committed in the 1930s when it refused to deploy its monetary tools to avoid a sharp deflation that substantially worsened the Great Depression” (p. 409).  Among the Fed's more notorious errors during that calamity were its failure to expand its balance sheet sufficiently, through open-market purchases or otherwise, to offset the dramatic, panic-driven collapse in the money multiplier during the early 1930s, and its recovery-scuttling decision to double reserve requirements in 1936-7.

Of course, Bernanke's Fed didn't commit the very same mistakes committed by the Fed of the 1930s.  But, as David Beckworth had already recognized by late October 29, 2008, it made remarkably similar ones that also resulted in a collapse of credit.  "History," Bernanke  credits Mark Twain with saying, "does not repeat itself, but it rhymes” (p. 400).  If you ask me, Bernanke himself was a far better versifier — and a far worse central banker — than he and his many champions realize.


Addendum (1-12-2016, 6PM): As Forbes' Frances Coppola, in replying to my criticism of her in an earlier post in this series, claims that I am inconsistent in my various posts regarding to bearing of IOR on bank lending, allow me to clarify my position by means of the following précis:

1. IOR was implemented in October 2008 for the avowed purpose of checking bank credit expansion in response to the Fed's creation of fresh bank reserves.

2. In fact, IOR contributed to the fall 2008 wholesale credit crunch, most obviously by causing a dramatic decline in interbank lending.   Again, this contribution was anticipated by Bernanke and others responsible for the policy.

3. Once the rate of IOR exceeded the yield on Treasuries and other low-risk assets, as it did shortly after the program began, banks had an incentive to accumulate excess reserves instead of attempting to acquire such securities.  Thus the normal process of bank balance-sheet expansion and deposit creation in response to reserve injections was short-circuited.

4. IOR also contributed to the relative decline in risky bank lending by increasing the marginal opportunity cost of such lending.  This portfolio effect of IOR on risky lending was very small relative to that of increasing regulatory burdens, including capital requirements, especially after 2008.  But as at least some banks had both surplus capital and surplus reserves, capital constraints alone did not prevent IOR from also having some influence.

5.  Fed officials, including Bernanke, who would deny that IOR had the consequences I have just outlined, are at least obliged to reconcile their denials with the justifications offered for implementing the program in the first place.

  • Walker Todd

    Amen to George's presentation of the argument here, but I am sympathetic to the argument that banking stress tests, properly conducted, would be helpful in stabilizing public confidence in the banking system. I also agree with George and Kevin Dowd that "actually existing stress tests" probably do more harm than good. And I have no use for any Basel agreement beyond the first one; risk-weighting of assets for capital purposes is a fool's errand. — Walker Todd

    • Bill Bergman

      From Dowd's conclusion in "Math Gone Mad" — "The best insights into the future come not
      from math modeling but from ancient Greek literature, which reiterates again and again the
      fates of those who were foolish enough to defy the gods."

  • Milton Churchill

    "5. Centralisation of credit in the hands of the State, by means of a national bank with State capital and an exclusive monopoly." Karl Marx; Friedrich Engels (2015-12-02). The Communist Manifesto (p. 20). Skyros Publishing. Kindle Edition.

    The goal of the Fed is to make certain that selected privileged groups of people are made wealthy and stay wealthy, beyond anything imagined (in 1848) at the expense of others. The "workers" were, and still are, stooges, tools, whatever you want to call them. Workers, 167 years later, are still fighting it out with barely a penny to their names, while their share of Marxist government debt burdens continue to balloon. And, if that were not enough, their children and the unborn will inherit the only possible position left for them, preordained debt slavery. Bernanke is an idiot, a useful idiot, nothing more or less.

  • Milton Churchill

    George, my guess is that Richard Fisher is not impressed with Bernanke's book either.

  • Gary Anderson

    Three shocks in a row. First LIBOR exploding upward and crossing the Swaps interest line in late 2007, then NGDP falling as inflation didn't in 2007 and early 2008 and now this, interbank lending froze because the Fed became the interbank. Oh, and HIBOR is exploding today in China. Just FYI.

    • George Selgin

      "The Fed became the interbank." I like that!

  • Michael Byrnes

    I had thought that the collapse in interbank lending of reserves was simply due to the fact that, once the system was flooded with excess reserves, lack of reserves was no longer a meaningful constraint on bank lending. Thus no reason to borrow reserves. How am I wrong?

    • George Selgin

      You aren't wrong, Michael; but neither am I. Under normal circumstances, with zero IOR, the banks would have preferred having Treasuries and other riskless securites to holding (excess) reserves, and so would have held ordinary reserve ratios only, while relying on interbank borrowing for temporary needs, as usual. So the seeming dichotomy of "lack of demand" or "lack of supply" as reasons for the decline in interbank lending is in fact a false one in this case.

      • Gary Anderson

        I think there is a massive shortage of long bonds even if the banks preferred excess reserves. All for use in the derivatives markets as collateral.

        • George Selgin

          In late 2008 (the period that concerns me most), the short bond yields approached zero, but longer bond were still well above that.

          See also the discussion of the matter on Scott Sumner's blog back in 2010:

          • Gary Anderson

            So the central "interbank", lol, pays interest on excess reserves to keep short term rates higher, off zero? Interesting. Doesn't Sumner want to reverse it and have banks pay on the excess reserves, forcing them to lend and get rid of them? You are saying that would lower the interest rate to zero? That wouldn't work, his idea, that is.

            Slightly off the subject, but if long rates are low due to demand for bonds as collateral, the economy picking up won't force those rates up and don't they have to go up so banks can make a profit lending? Now they just profit on getting counterparties to their loans to take swaps, and the banks bet on low interest rates and the counterparties are stuck with higher fixed rates. Banks make big money on that arrangement, except when LIBOR went haywire in 2007. Then they didn't make money on that arrangement. Now the Fed is predisposed to keep long rates low by creating massive demand for bonds, and by having the banks bet on low rates.

          • George Selgin

            Gary, I haven't taken a stand on negative IOR, though I am aware of various difficult problems that idea raises. My claim is merely that zero IOR would have been better than positive IOR for the circumstances prevailing in late 2008 and since.

            On rates rising as the economy "picks up," I think they will tend to, both because the improvement will reduce the demand for liquidity, and because it will improve opportunities for at-risk lending. But I also agree that Fed actions might counter that tendency.

          • Rob

            Hi George, if you look at the asset purchasing program by BOE you can see the 6-month moving growth rate in M4 (liabilities to private sector seasonally adjusted) responding to the creation of reserves in the UK financial system by the BOE. My understanding is that BOE did not put an interest rate on reserves (correct me if I'm wrong). This is in contrast to the M2 growth rate for the US of ~2% or lower over the equivalent period.

            Charts attached are created from the data provided by the BOE:(

            (Disclaimer: this was a quick bit of analysis and I haven't really dived into the BOE actions in great detail)

          • George Selgin

            Thanks much for this, Rob. I need all the grist I can get for my mill, for I don't think any of my posts have generated more skeptical feedback than this one has!

          • Rob

            Glad to offer some assistance. I think your argument over these three posts is well structured. The fact that Fed officials have admitted their intention behind putting an interest on reserves was to neutralise QE is startling and something that seems to be overlooked by much research.

            I tried to tweet a reply to John Taylor on this point, asking what the impact of introducing interest on reserves is on his rule/model but haven't received a reply.

            Your opportunity cost argument around Interest on Reserves being more attractive than riskier / senile loans seems to be supported by Alan Greenspan at the very least. He has said the same thing in nearly every interview at the Council of Foreign Relations since 2008, always giving the example of JP Morgan seeing those loans not worth the risk compared to holding reserves and getting the 25bps from the Fed. He also mentioned that when you factor in the zero capital requirements of holding the reserves, it is an even larger incentive for JP Morgan to ignore the riskier loan market – effectively creating the liquidity trap.

            Quote from the recent interview: "If you move the (IOR) rates all the way down, then senile loans which are risky and have reserve requirements all of a sudden become more attractive. But if you keep moving the rate up, you basically neutralise the system, and the way you can tell is despite the huge increase in the monetary base which moves directly with the asset side (of the Fed's balance sheet), the money supply which is the transaction base which creates economic activity and inflation….hasn't gone up all that much…The money supply has got to go up before you see any expansionary effects from QE1, 2 or 3."

            Greenspan seems to mention it so often that I think he is almost taking a shot at Bernanke for implementing the policy.

          • George Selgin

            I agree, Rob, that the Greenspan quote is very revealing. It seems that he and I are of precisely the same opinion on this. That at least makes me feel somewhat less self-conscious about being in a tiny minority on this issue.

  • JKH

    Continuing on from my comments under the previous post, I'll begin by lifting a comment about the operation of the reserve system that I wrote recently in response to a Scott Sumner comment directed to me at the ‘Uneasy Money’ blog:

    “Under QE reserve conditions, the IOER rate sets a floor for the target fed funds rate. If the target funds rate is positive, the IOER rate must be similarly positive. Otherwise, arbitrage will drive both the funds rate and similar money markets to around zero. Conversely, under QE reserve conditions, a zero IOER rate is only consistent with a fed funds target of zero or thereabouts. Under QE reserve conditions, the issue is always the funds rate target. The IOR rate is a fallout from that.

    Under pre-QE reserve conditions, the issue was also the funds rate target. The IOER rate was zero in that environment, only because ER quantities were restricted by Fed management to the point of causing the funds rate to bite at the Fed’s chosen positive target interest rate.”

    That’s how IOR works. The popular economists’ argument against the payment of interest on reserves is misdirected in fundamental way. The payment of interest on reserves is a non-optional structure feature required to support the target fed funds rate in QE excess reserve conditions. If the target funds rate is positive, and IOR is zero, the effective fed funds rate will decline toward zero. And if the target funds rate is negative, and IOR is zero, the effective funds rate will drift up to zero. In general, if the target funds rate is non-zero, but IOR is zero, arbitrage will force the effective funds rate to zero, which is a contradiction in policy. The issue is always the target funds rate – not IOR.

    Thus, the criticism in general you desire to make about the Fed’s handling of IOR should not be directed to IOR – it should be directed to the target funds rate. And consequently, the disparate pieces that constitute your argument about the interpretation of IOR itself (and the role of bank
    reserves) do not hang together. If your argument instead was that the Fed was too slow to drop the funds target – that is different. Such an argument can reasonably be made. But it is inherently illogical (“wrong-headed” – to borrow a characterization) to frame the argument in terms of the payment of interest on reserves – when IOR in a QE excess reserve environment is a non-discretionary function of the target funds rate. And this error applies a fortiori in the current case where the Fed has started the process of increasing the policy rate. The issue remains the target funds rate. The corresponding IOR is required to be in place to support the target rate so long as QE excess reserve levels remain outstanding. This is essential to the Fed’s QE exit strategy.

    The next problem I see is that there is a recurring type of misrepresentation in these posts having to do with the interpretation of statements made by other writers about the reason for IOR. The primary example in this post is a quote from Bernanke:

    “[W]e had been selling Treasury securities we owned to offset the effect of our lending on reserves… But as our lending increased, that stopgap measure would at some point no longer be possible because we would run out of Treasuries to sell….The ability to pay interest on reserves…would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed (p. 325).”

    And your critique of this excerpt in your the post is:

    “It is hard to see how Bernanke can insist that the Fed's decision to pay IOR had nothing to do with the drying-up of the federal funds market given the justification he himself offers …”

    That assertion has no relevance to the Bernanke quote. It is a misinterpretation of what he is saying. Bernanke in fact is saying the same thing that I have explained above and in comment at your previous post. IOR serves as a required floor for the effective fed funds rate. This is an entirely different idea than an intended “the drying-up of the federal funds market”, which is the meaning you have ascribed to it. Bernanke is simply referring to the function of IOR as preventing the funds rate from declining below target. He’s not saying that he wants to discourage funds trading at the intended target rate. Questions about why the funds market became less active are quite outside the meaning of this quote, and there is no contradiction with anything he has said elsewhere on that score.

    Third, the “drying up” question needs to be looked at in proper context, which is not that implied by the previous quote. The answer is simple. The purpose of the funds market is so that banks can rebalance their reserve positions. Here it helps to know something about how banks actually manage their reserve positions in both pre-QE and QE environments. The upshot in the QE case is that once QE reserves have finally been created in a quantity reliably sufficient to ease the stress in short term money markets – that stress having resulted from forces put in play at various early stages of the financial crisis – there is a natural (and operationally obvious) tendency for interbank activity to decline. The reason is simply that in the wake of these extreme crisis conditions, the system finally has reserves sufficient to buffer the ebbs and flows of the customer funds activities that are the normal cause of the need for more active interbank adjustment in a more tightly run pre-QE reserve setting. And the system buffer finds its way to a distribution of individual buffers across banks. With that excess reserve protection in place against unanticipated reserve clearing effects, and as that protection becomes increasingly surplus as markets recover, the demand for interbank borrowing naturally declines.

    Moreover, this reduced velocity of interbank lending under QE is unrelated to the essential question of whether banks are expanding their commercial lending books. That question relates to the assessment of credit risk, the prospects for an economic return on equity, the appropriate allocation of capital for the risk taken, and the availability of capital to be allocated – all of that requiring a matching up with an actual availability of commercial lending opportunities that can act as a potential supply of the desired type of credit risk. And regarding the issue of capital adequacy, it is also the case that your point that banks eventually had sufficient capital to lend but didn’t (apparently) has no direct causal connection to the IOR question. Banks that generate internal capital and that have satisfied both regulatory and internal standards for capital adequacy and that have access to excess capital as a result, but that can’t find economic lending opportunities to deploy that capital, will then return that capital to shareholders through dividends and/or share buyback programs, rather than compromise their ROE and credit standard policies. This menu of options is fundamental to a disciplined capital management process, and is totally unrelated to the presence of excess reserve balances at the Fed.

    (This being said, your third post does seem to have become more sensitive to the facts of the drivers of commercial lending – and I can understand Frances Coppola’s puzzlement about that change.)

    Excess reserves are the conduit through which the Fed controls the effective fed funds rate trading level – both in pre-QE (by quantity) and QE (by IOR) environments. And excess reserves held as deposit balances by commercial banks are the conduit through which the banks adjust their nominal core asset-liability matching profiles – using money market operations in the active management of liquid asset and short term liability positions to achieve this as necessary. The business of banking at its core is about the effectiveness and profitability of commercial and household lending and deposit activity. Liquidity management and reserve management are essential supporting operations to that main activity. But they are not the central activity of banking. So this notion that the effectiveness of QE is somehow measured in terms of the velocity of fed funds trading or the extent to which banks are buying treasury bills in their money market operations is way off the mark as an attempt to explain IOR in operational context. And while I won’t plunge into an analysis and response to the minutiae of the interconnections you develop using the graphs in the post, the unavoidable conclusion is that there is a plethora of confused causality and erroneous post hoc propter hoc association that doesn’t square with facts about the how bank reserve management actually functions, and here I am also sympathetic to Ms. Coppola’s impressions (as well as the rest of her recent piece.)

    I’m afraid there is a considerable misunderstanding by much of the economics profession about how banks operate in the context of the Fed’s management of system reserves – in both pre-QE and QE cases.

    • George Selgin

      I think that "the criticism in general you desire to make about the Fed’s handling of
      IOR should not be directed to IOR – it should be directed to the target
      funds rate," gets to the nub of our disagreement, JKH. For I don;t see my criticism of IOR–which has always been a criticism, not of the tool itself, but of the decision to set the rate where it was set in 2008 and for a long period afterwards, which in my opinion amounted to setting an overly tight monetary policy. I am perfectly happy to concede that the issue was "really" an overly-high ffr target. But this is a matter of semantics. IOR was the instrument employed beginning in October 2008 to implement that target. Had there been no IOR, other things equal, the result would have been greater monetary expansion, and a less severe collapse of spending.

      By the same token, it seems to me that, in interpreting Bernanke's statement that "Banks would have no incentive to lend to each other at an interest rate
      much below the rate they could earn, risk-free, on their reserves at the
      Fed," as implying that he understood that IOR, at the rates ultimately chosen by the Fed, would discourage interbank lending, when the effective interbank rate was in fact substantially below the IOR rate.

      Finally, I regret that I have the impression to you and Ms. Coppola that I considered IOR a major cause of reduced (non-interbank) lending. What I do believe is that it reduced the deposit-reserve multiplier by discouraging banks from trading reserves for low-risk securities. My understanding here is precisely the same as that offered in the Keister-McAndrews paper I refer to in my first post, and quote from in my reply to Gary Anderson below. Perhaps I have misunderstood those authors; if so I would be glad to have my misunderstanding corrected.

      • JKH

        Broader strokes continued (there are several finer points I might revisit later):

        I finally looked at the paper you referenced, and it was not the one I had thought I
        recalled, which was Keister, Martin, and McAndrews in 2008 titled “Divorcing
        Money from Monetary Policy”. The main reason I liked that paper is how the
        authors described the various options available to central banks in controlling
        the effective trading level of the policy interest rate, in part depending on
        the mode for supplying the quantity of excess reserves (an example of the
        latter being the difference between pre-QE and QE excess reserve strategies as
        I have used those terms).

        Scanning both papers again, the reason I liked the 2008 paper did not have to do with
        the way in which the multiplier was referenced by two of the same authors in
        the paper to which you referred. But perhaps this should be qualified – note the
        phrasing “conflicts with the traditional view of the money multiplier” along with “the textbook presentation of the money multiplier assumes…” Occasionally this sort of traditional/textbook reference can be code for an author’s somewhat qualified or even non-endorsement of such textbook explanations. I don’t know if that’s the case here, but it’s beside the point anyway.

        What is more to the point is that I believe that the textbook explanation of the multiplier is wrong, and at least must be qualified to the point that it becomes almost unrecognizable as a statement of how banks work.

        This requires an intricate discussion that I’ll try to compress. So this is quick and dirty, and it’s all pre-QE as description:

        The first point requires visualizing bank operations as between liquidity management and everything else. In liquidity management, it is the bank’s money market operations that steers the ship. That includes reserve management along with all the other asset liability positions that are used to respond to short term market conditions in conjunction with reserve management. The example closest to the point you want to make I think is that of a sudden Fed easing in the supply of excess reserves. Indeed, that will cause bank reserve managers to go out and buy liquid assets which indeed creates money as you have described. They will also back off bidding for
        interest sensitive money market funding. This activity normally causes a very rapid adjustment in money market rates. In such an example, the reason for the Fed’s intervention is that the fed effective rate had probably drifted up from target. And so the objective of the reserve easing to get that rate and other related rates back down. But the result in general will be a banking system expansion at the margin, as you have described.

        This general process of excess reserve adjustment by the Fed (again pre-QE) is highly sensitive. Interest rates respond quickly in either reserve expansion or reserve contraction mode. Money market conditions can shift back and forth with marginal system balance sheet expansions followed by marginal balance sheet contractions. No doubt one might track this very short term cyclical tendency in a normally functioning market, not only at a given level of the funds target rate as the Fed continuously aims to steer the Fed effective rate to that target, but also at different levels of the fed funds target rate, as the Fed moves the policy rate up and down through longer term cycles. Bank liquidity goes through superimposed cycles of different lengths in this way.

        That probably sounds like hand waving, but that’s how it worked. And the further critical point is that the Fed’s provision of above average (for example) excess reserves in this context is typically extremely short term – I mean a matter of days – until the above average component has done its work and then must be withdrawn. And conversely in contraction mode. These reversals are absolutely necessary in order to stop the desired fed funds rate from overshooting. So the multiplier has no chance to work in the sense of the algebraic iteration that you see in textbooks. And the balance sheet expansions and contractions due to liquidity management per se can be very ephemeral – because the supporting reserve management easing or tightening must be reversible in order to control the end result for the funds rate.

        Moving back to my point on commercial lending and capital management. This is the supertanker of the banking business (banking in simplified form). This is where the issue of balance sheet expansion can be examined on a longer term trend basis, and this is the context for the assessment of the relevance of the textbook multiplier description. And that description is wrong.

        The way it works is that commercial lending activity takes place over time and because balance sheets must eventually balance (that’s a simple way of describing the causation), system asset expansion is accompanied by liability and capital expansion, including reservable deposits. This results in increments to required reserves. The Fed responds to the activation of those incremental requirements by supplying the necessary reserves to accommodate them. It must do this, because if not, the new requirement would cause a sudden decline in excess reserves, and the funds rate would go through the roof. So the process of supplying required reserves works in tandem with the process of managing the excess reserve position in such a way as to make control of the funds rate work seamlessly, even as required reserves increase over time. And as I described earlier, the commercial lending book is run quite separately from considerations of reserve management. The excess reserves that the money market operation sees are for purposes of clearing payments. From the Fed’s perspective, the objective is to facilitate that process while steering the funds rate – via highly sensitive control of excess reserve supply. The main commercial/ household lending and deposit operations do not see this, nor care about it.

        So the textbook causation is both inapplicable and backwards respectively in these two fundamental ways. In the case of liquidity operations, the multiplier never gets a chance to get going, because excess reserves are managed in such a high frequency fashion that expansion and contraction of excesses occur in regular cycles. And in the case of commercial lending and associated trend deposit expansion, the causation is from balance sheet expansion to the Fed’s provision of newly required reserves after the fact.

        That’s all pre-QE Fed. And probably enough for now.


        Very much appreciate your openness in engaging. That is too rare.

        Full disclosure – I managed the reserve position of one of the major Canadian banks at an executive level throughout the Volcker period. I take some liberty in describing Fed operations, because the two systems in terms of reserve management were very similar at that time – and I used to watch the US market closely when doing the Canadian job.

        • JKH

          Referring to several other points in your comment above:

          “IOR was the instrument employed beginning in October 2008 to implement the Fed's target. Had there been no IOR, other things equal, the result would have been greater monetary expansion, and a less severe collapse of spending.”

          Had there been “no IOR”, then IOR would have been be zero and the fed funds target would have been changed and been announced as zero to be consistent with an IOR of zero as a floor rate for the funds target. Remember that the Fed still had a positive funds target, and had improvised to maintain that target operationally through the use of special issue T-bills to drain reserves, and ultimately through the imposition of a positive IOR to set a floor for the funds rate. Under an alternative hypothetical scenario in which the funds target was set to zero, the adjustment of market rates down to a similar level would have been immediate through the standard arbitrage process. With the rapidity of such an adjustment, the amount of monetary expansion that would have been associated with that is debatable. The market moves to eliminate those kinds of opportunities very quickly, just as it did regularly when the funds target was changed in the pre-QE environment.

          “He and his colleagues in fact chose to set the IOR rate above the effective interbank rate. It is the rate choice, not that of implementing IOR per se, that can be understood as having been made with the understanding that it would cause interbank lending to "dry up."

          As I recall, I think what happened is that the Fed temporarily lost control of the funds rate while making the transition into QE, due to the complications associated with the special T bill reserve drain and the lag in introducing IOR. Then they implemented IOR as the new floor mechanism, consistent with the funds target. Again, I think your complaint should be with the strategy for the funds target, which I suspect you believe they should have dropped more quickly and formally, in effect. The fact that the interbank rate was trading below the funds target during the transitional period was the result of QE related pricing dysfunction – it was not the intention that it trade at that level and that level should not be viewed as a normative basis for setting IOR. That said, this type of transitional dysfunction blended into the issue of a permanent dysfunction in the form of the fact that the agencies who keep balances with the Fed don't earn interest on them, which leads to instances of sub-IOR arbitrage lending and a funds rate that can drift a little below the target rate. They need to fix that.

          “Had it not been for IOR, banks would not have held such high ratios of Fed balances to deposits, but would instead have held more low-risk securities, and that there would therefore not have been such a pronounced decline in their reliance upon overnight loans. My view, in other words, is that IOR reduced the opportunity cost of holding reserves relative to the cost of resorting to overnight borrowing, to a nontrivial extent.”

          Again, “no IOR” means IOR = zero, and the fed fund target would have to be set to zero or a range in the area of zero to be consistent with that choice for IOR. And I repeat my point above that the announcement of such a funds target change and accompanying IOR would have involved a swift readjustment of market rates to the same general level through the normal arbitrage process. And again, the extent of the addition to securities portfolios would be debatable. Markets and opportunities adjust quickly.

          • George Selgin

            (Positive) IOR was introduced because the Fed had exhausted the other means you mention for achieving (or trying to achieve) its ffr target, which target was by then in fact no longer consistent with the actual ffr. So, it was not necessary for the Fed to "set" its target to zero for zero IOR to have made a difference: the non-zero Fed target would have continued to be irrelevant, to be sure, just as was the case before IOR; but the lack of positive IOR would have meant more actual fed funds trades and security purchases, with yields and actual ffr tending toward zero. But a less constrained multiplier would have helped to arrest the decline in spending (NGDP), which is to say, would have made any given amount of QE more effective than with positive IOR. In other words, a relatively ineffective non-zero ffr target would have been more expansionary than a similar target made meaningful by means of a lower-bound established (albeit imperfectly) using positive IOR.

            In my opinion, the fed's attempt to maintain its target ffr–by hook or by crook, and specifically by introducing positive IOR–when events had already carried the equilibrium rate below the targeted one, were contractionary, and for that reason self-defeating.

          • JKH

            “So, it was not necessary for the Fed to "set" its target to zero for zero IOR to have made a difference: the non-zero Fed target would have continued to be irrelevant, to be sure, just as was the case before IOR”

            I agree with that. Just that it might be a tad embarrassing to have the FOMC statement and press conferences remind everybody on cue that “our fed funds target rate remains both unchanged and irrelevant”.

            But it’s a wild and interesting idea to have had the Fed run a deliberately ambiguous policy to slow down the process of arbitrage as rates on short term securities ratcheted down toward zero. I think that’s what you’ve suggested. But I don’t think they want to run the institution that way. That ambiguity amounts to the market betting on the probability of the Fed exercising a floating policy option of sorts, one way or the other, which would create a lot of volatility. I don’t know – it may have increased the amount of securities buying by banks. But it's pretty wild. I’d have to think more about that one.

            My way of putting it assumes the desire for clarity in their policy objectives. They were heading toward IOR behind the scenes leading up to its actual implementation, and their objective was clearly the IOR rate and fed funds target that they announced at implementation. They had a choice all along to adopt a more aggressive policy of dropping rates formally to zero.
            They chose formal gradualism, in the context of the type of easing policy that folks like Sumner and yourself wanted to see. And given the framework that we ended up with, I think your preference within that framework (non-ambiguous) would logically suggest a double zero policy, more quickly rather than less quickly, roughly speaking (In Sumner’s case, negative perhaps).

          • George Selgin

            All agreed. I think the Fed was too inclined, on the other hand, to insist on "controlling" ffr even if that meant controlling it the wrong way. Hitting the target became more important than having that target where it needed to be for the sake of avoiding avoidable macroeconomic contraction. I actually have been contemplating a post dealing with this very issue.

          • George Selgin

            By the way, I think our understandings are converging pretty rapidly here.

            FWIW, John Allison, my former boss, and someone who knows a bit about banking,has also been very critical of my claims regarding IOR, especially my blaming it for discouraging bank lending (as opposed to merely causing banks to prefer reserves to low-risk securities.)

          • JKH

            "By the way, I think our understandings are converging pretty rapidly here."


            That's good.

            As in:

            "I am perfectly happy to concede that the issue was "really" an overly-high ffr target. But this, in my opinion, is a matter of semantics."

            Although I think its more than semantics. I think its clarity on monetary architecture and its inherent causation mechanics. One reason I say this is that the fed funds target idea is universal in the sense that it covers both pre-QE and QE excess reserve environments in a uniform way. But the underlying IOR implications are asymmetric. IOR is identically zero in the first while floating in the second. So I think its helpful to unpack the logic of how it works that way.

          • George Selgin

            In principle, an adjustable and properly set IOR is better than fixed. It happens in the case at hand that I believe the original fixed IOR (=0) was closer to the optimal rate than the higher rate actually chosen.

          • JKH

            "In principle, an adjustable and properly set IOR is better than fixed."

            Sorry I'm not more familiar with your work. Does that mean you do not favor a full QE exit that returns the system to its previous style of operation with a fixed IOR of zero?

            My reading of Yellen and Co. so far leads me to believe they want to go back to that, but I could be wrong.

          • George Selgin

            No. I don't mean that changing IOR should substitute for Quantitative Easing and Tightening. I mean that in principle it is better to have more tools than fewer. ("In principle" because one must also consider how certain tools may be more prone to abuse, and therefore not worth having in practice.) I believe the large real size of the present Fed balance sheet itself a negative development. And I generally believe that the best IOR is one that sets the rate no higher than the yield on short-term Treasuries, and perhaps slightly below it. Finally, I have my doubts about whether the Fed should pay any interest at all on excess (as opposed to required) reserves. In other words, I'd rather see IOR used to achieve efficiency in reserve holding, and nothing else, as was its originally-intended purpose.

          • JKH

            It seems like the upshot of what you've been aiming for is a configuration of interest rates that motivates banks to go out and buy treasury bills, thereby expanding balance sheets and the money supply. And to do this you want to increase the opportunity cost for banks to remain in reserves by making it economic for them to buy treasury bills.

            I see problems with this. IOR is an administered rate. Treasury bill rates are market rates. Therefore, to get a configuration for example where IOR is less than the Treasury bill rate, you need to index the IOR rate to the Treasury bill rate – e.g. IOR is set at a discount to the 3 month Treasury bill rate, adjusted daily or weekly. Even that is inefficient due to intra-day or intra-week volatility in the current market spread. In any event, your idea would seem to be to create an ongoing arbitrage opportunity for banks to expand their balance sheets by buying bills. But there are several problems. First, that kind of structural arbitrage design means there is no downside anchor or floor for IOR. If it “works” as designed, banks will bid up bills (bid down the yield) because of the continuing margin opportunity, and the bill rate will move toward zero, and IOR will follow after. And this will happen quickly. So that simply amounts to an awkward way of getting rates down to zero. Second, bank reserve managers are smart people (I don’t mind saying). They understand how the system works. In particular, they have to develop skills in game theory and the fallacy of composition. For example, the reserve manager at JP Morgan would understand that such a scheme to encourage him to buy treasury bills operates with the same effect in the same way on the reserve manager at Bank of America. And both of them know that the total amount of reserves in the system is under the control of the Fed. And they know that if all the reserve managers undertake such a strategy in a proportionate way, then the net effect on the reserve distribution across banks could well be minimal – because the deposits created just come back to their institutions in proportion. That means that their collective efforts to "get rid of" reserves as individual banks will become somewhat self-defeating. It means that the consequence of buying bills is to expand each bank’s balance sheet, and that the resulting economics is related to the interest margin spread between Treasury bills and deposits – not the opportunity cost of holding reserves, because they will still hold those reserves. And at some point, probably very quickly, banks become concerned about the bill/deposit interest margin as they drive bill rates down toward zero. So they will stop doing it because it’s not accomplishing a whole lot. And this will happen quickly. Again, such a tied interest rate arrangement is simply a weird way of forcing rates down to zero.

            Other parts of your comment puzzle me. I don’t understand the meaning of the first sentence – it doesn’t seem to correspond to the question I asked. Next, if no interest is paid on QE excess reserves, then banks will force rates to zero – it’s that simple. Finally, I also don’t understand the meaning of your last sentence.

            Let me just add that this notion over the past few years that 25 basis points of IOR interest margin at the zero lower bound has been material to the economics of the banking system in aggregate is pretty desperate. It's about $ 5 billion a year pre-tax. Call it $ 3 billion after tax. JP Morgan alone makes $ 20 billion a year after tax or so.


            The Bank of Canada ran a floating bank rate from 1980 to 1994. It set the bank rate (LLR rate) at 25 basis points above the weekly auction 3 month treasury bill rate. But that was in a pre-QE type reserve environment, where the BoC steered the general level of market rates – include the outcome of the weekly treasury bill tenders – as a result of its very tight control over the quantity of non-interest earning excess reserves. It anchored rates that way. So it wasn't comparable to the current US case of a QE excess reserve environment.

          • JKH

            And I return to my earlier theme as well and say, with respect, that I really don’t think the economics profession in general has a solid understanding of how the Fed operated the excess reserve setting pre-QE. Perhaps that's too much to expect, but given the importance of the mechanism as to how things work, it seems essential. I’m coming to the conclusion that there is a general type of misconception along the lines that if the fed funds rate is at 1 per cent instead of 2 per cent, for example, that there is somehow “more liquidity” in the funds system because of that. That does not necessarily follow, according to the precise mechanics of how such a rate decrease is engineered by the Fed. So I think there is a major confusion about how liquidity as a quantitative concept relates to the Fed funds rate as a pricing concept – insofar as the Fed’s management of excess reserves is concerned. And if this relationship is not understood on a pre-QE basis, it stands to reason that the transition to an explanation/understanding of the same thing in the context of QE will be all the more difficult.

  • JP Koning

    Hi George,

    I agree with the gist of your argument that IOR of 0.25% was too high and contributed to a weakening of NGDP. No IOR whatsoever, or IOR of 0%, would have been better. But when all is said and done, how much of a boost would one final 0.25% rate cut have provided? Maybe a bit, but it surely was no silver bullet. I think the inevitable question is, given that the Fed was setting the interbank rate too high, and given the fact that QE was a mistake (as you maintain in your first post), should the Fed not have decreased the fed funds target to not just 0%, but continued on to -0.25%, or -0.5% or even -1%, especially now that it had the tool to do so in IOR? If not, what could the Fed have done (aside from not getting into the problem in the first place)? Forward guidance?

    • George Selgin

      JP, briefly, I have never said that IOR=0 was optimal; I have also acknowledged (in one of these posts) that at some point the "natural" ffr may have gone negative. But what seems to me to matter most is the difference between IOR and the rate on low-risk, liquid securities. Once IOR is low enough to discourage banks from preferring cash to such securities, lowering it further shouldn't make much difference. Allowing that, as banks swap reserves for securities, the yields on the latter also decline, the appropriate IOR rate will also decline. How low it needed to go, back in the latter months of 2008, to suffice to get banks back to ordinary excess reserve holdings, is of course a good question, which I don't pretend to be able to answer.

  • EDW

    I disagree with all 5 of your points listed above, but for the sake of brevity I'll focus on #2 & 3:

    2) The reason banks no longer needed to lend to each other in the Fed funds market (and thus the "dramatic" decline in interbank lending) was precisely because QE supplied them with an enormous amount of reserves. Hence, no individual bank needed to bid for any additional reserves in the Fed funds market. There's nothing sinister here.

    3) If it's indeed true that IOR led banks to have "an incentive to accumulate excess reserves instead of attempting to acquire such securities" (e.g Treasuries and other low-risk assets, as you mention), then why did the line item "Treasuries and Agency Securities" within the Fed's H.8 release (showing the aggregate balance sheet of commercial banks) increase both in an absolute sense, and as a percent of total assets, every year from 2007 onwards? I'm waiting….

    • George Selgin

      EDW, Michael Byrnes made the same point as yours concerning item 2, so please see my reply to him below. Also, I don't believe that "sinister" characterizes my view correctly. In fact, Bernanke and other Fed authorities were quite open about the goal of IOR (that is, of starting positive IOR payments in October 2008), saying it was to keep Fed emergency lending from spilling-over into the federal funds market. (My point #1, with which you also claim to disagree.) I can give you half a dozen Fed sources on this. My complaint is that, sinister or not, this step was contractionary and, therefore, misguided.

      Concerning 3, you ask the wrong question. Look back again, please, at my last chart. The right question is, why, given trillions of new reserves to play with, did the banks increase their excess reserves by almost that entire amount, while adding only relatively trivial amounts, in comparison, to their holdings of Treasuries and other low-risk securities? Why such a dramatic change in their liquid asset mix, which had in the past always involved keeping reserves close to their required levels, notwithstanding how many such the Fed generated over the years? Do you suppose that the change had nothing to do with the fact that, before October 2008, T-bills and other securities yielded more than reserves, while afterwards they paid less? Have you a better explanation for it? I'm waiting…

      • EDW

        I read your response to Byrnes and I don't really understand how your other arguments follow from it. Here's your quote:
        "Under normal circumstances, with zero IOR, the banks would have preferred having Treasuries and other riskless securites to holding (excess) reserves, and so would have held ordinary reserve ratios only, while relying on interbank borrowing for temporary needs, as usual."

        What is an "ordinary" reserve ratio to you? Are you talking about required reserves? If I'm reading this right, you're saying that in the absence of IOR banks would be holding an additional $2.3T (the amount in excess reserves of commercial banks) in Treasury and agency securities, turning all their excess reserves into required reserves. What proof do you have of this? Where in the world has a central bank increased their reserves by almost $3T, and then banks took all of that and bought Treasuries and short-term bonds? Even if they did, then what? Credit markets suddenly burst open for everyone? As you point out, several countries in Europe have implemented negative rates on reserves. Have their economies taken off?

        Re: 3 – Their liquid asset mix changed because the Fed blew the walls out on the reserves in the system, like they never had before. Banks have to bid for Treasuries like everyone else does – they can't just buy up every security in existence because they feel like it. The question you should be answering is, why did banks buy Treasuries and agency securities at all, let alone increase their holdings of them as a percent of their balance sheet, if this 25 basis point "windfall" is so spectacular?

        • George Selgin

          Yes, by "ordinary" reserve ratios I mean ratios close to those that obtain when banks hold required reserve levels only or (allowing for unusual liquidity needs) a somewhat larger, ratio than that. And no, I don;t imagine that bans would have bought $3T of Treasuries in the absence of IOR, partly because before they did Treasury yields would have reached zero themselves, making banks prefer reserves even at IOR = 0. But there is a more important reason: had the banks reason to used extra reserves to buy any substantially greater amount of Treasuries, the Fed would not have resorted to such large asset purchases, for much small purchases would have sufficed to generate a much larger expansion of bank balance sheets (the multiplier would have been substantially greater than 1, instead of falling t less than 1). A higher reserve-multiplier has to be allowed for, along with a declining yield on Treasuries, in contemplating the counterfactual.

          Your question as to why banks buy Treasuries and agencies at all when they can earn 25 bps on reserves isn't hard to answer. Reserves don't dominate all Treasuries and agencies in rate of return. But under IOR=0 Treasuries and agencies of all sorts usually dominate reserves–hence the historical tendency of banks to hold very few excess reserves. That 25 basis points isn't a "spectacular" amount doesn't matter: what matters is how they stack up compared to the (also unspectacular) yields on other low-risk assets.


          • Gary Anderson

            George, we know the LIBOR rate came down after IOR was implemented. But that could have been partly a fraud, the LIBOR scandal. I am wondering if not trusting LIBOR had any impact on the Fed instituting IOR in the first place? It was a tightening, but was there any other way of protecting the banks?

            We know that the rise of LIBOR destroyed subprime lending more than it destroyed interbank lending. Interbank lending as a casualty of Lehman was a delayed reaction.

  • Michaelryan27

    ok – new guy on the block. #1 – sounds good.. #2 Why isn't it the other way around. Why isn't it that the QE process eliminated the demand for inter-bank loans because QE reduced the banks needs for borrowing? #3 sounds good – Doesn't IOR also reduce the banks interest in making loans? – your point in #4.

    • George Selgin

      Sorry for this late reply, M. The answer to your question is that 0 interbank borrowing isn't usually optimal. Instead, banks shed excess reserves by buying bonds until they (or some of them) return to a point of having to occasionally borrow overnight. The equilibrium with zero interbank activity is, therefore, not attributable to QE. It is due to a change in banks' preference for reserves relative to Treasuries. Regarding #3, IOR most obviously reduces banks' demand for Treasuries (or does so when the IOR rate exceeds the Treasury rate); but in the long run there is some influence on other sorts of bank lending as well.

      • Michaelryan27

        Hi George – thanks. I didn't mean to imply that 0 inter-bank borrowing/lending was optimal. I just meant that given the extra reserves, the demand for Inter-bank Borrowing is reduced. Fewer banks are at their limit. There will always be inter-bank borrowing at but at a much reduced volume. Unless of course just a few of the banks benefited from QE. On a second thought, I am also concerned about the QE assets owned by the Fed. Has anyone ever discussed what price was paid? What level of discount did they receive for the crappy CDO's. If it was 80 cents on the dollar – maybe ok???