Proposals to Allow Federal Reserve Banks to Pay Interest on Reserve Balances: The Issues Behind the Legislation

Proposals to Allow Federal Reserve Banks to Pay Interest on Reserve Balances: The Issues Behind the Legislation

Order Code RL30874
CRS Report for Congress
Received through the CRS Web
Proposals to Allow Federal Reserve Banks
to Pay Interest on Reserve Balances:
The Issues Behind the Legislation
Updated March 5, 2002
Walter W. Eubanks
Specialist in Economic Policy
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

Proposals to Allow Federal Reserve Banks to Pay
Interest on Reserve Balances: The Issues Behind the
Legislation
Summary
Depository institutions have been maintaining considerably smaller reserve
balances at Federal Reserve banks (the Fed) since 1989. Some observers believe this
situation could potentially lead to volatility in short-term interest rates. Limited
reserve balances at the Fed affect the pool of funds available for interbank lending and
borrowing. However, there has been little evidence of interest rate volatility so far.
As an incentive for depository institutions to maintain higher levels of reserve
balances, bills S. 229, S. 524, S. 601, H.R. 974, and H.R.1009. in the 107th Congress
would allow depository institutions to earn interest on their reserve balances at the
Fed.
For the Fed, these additional balances would provide a better tool for conducting
monetary policy. The Federal Reserve is able to change the levels of these balances
by buying U.S. government securities from and selling U.S. government securities to
depository institutions. By influencing the aggregate level of these balances, the Fed
influences the price (the interest rate) depository institutions charge each other for
interbank transactions – the federal funds rate. The federal funds rate serves as the
benchmark for most short-term interest rates.
Paying interest on balances at the Fed is expected to have a negative impact on
the federal budget. CBO’s April 3, 2001 cost estimate of H.R. 974 was that the bill
would not have any net effect on annual revenues over the 2002-2006 period, but
would decrease revenues after 2006. That revenue loss would total approximately
$1.2 billion over the 2006-2011 period.
Improvements in reserve balance management might explain why there has been
little evidence of interest rate volatility and monetary policy ineffectiveness. Both the
Federal Reserve System and the depository institution sector have developed
technology, reserves and cash management strategies, and procedures that have
helped to improve interest rate stability and monetary policy effectiveness.
Specifically: (1) the Fed has taken significant steps toward improving the timeliness
of providing account information to depository institutions, (2) more frequent open
market operations are increasingly geared to daily payment needs, (3) a shift to lagged
reserve requirements has given depositories and the Fed advance information on the
demand for reserves, (4) improved procedures for estimating reserve demand have
used reserves more efficiently, and (5) the Fed has allowed depository institutions to
sweep transaction accounts to reduce reserve balances. Partly as a result, required
reserve balances at Federal Reserve Banks have declined from more than $37 billion
in June 1988 to a little more than $4 billion in the first quarter of 2000. These balances
rose to about $9 billion in last quarter of 2001. This dramatic decline occurred
without serious volatility in short-term interest rates or a noticeable deterioration in
the effectiveness of monetary policy.
This report will be updated as legislative and economic developments warrant.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The Purposes of Federal Reserve Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Facilitate Check Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Facilitate Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Level of Reserve Balances at the Fed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Required Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Reserve Balances at the Fed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Vault Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Required Clearing Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Excess Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Reserve Balances at the Fed: a Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 8
How Depository Institutions Manage Reserve Balances . . . . . . . . . . . . . . . . . . 9
Managing a Single Deposit Account at the Fed . . . . . . . . . . . . . . . . . . . . . 9
The Profit Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
The Danger of Relying Too Heavily on Vault Cash . . . . . . . . . . . . . . . . . 10
If the Fed Pays Interest on Reserve Balances . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Two Agencies’ Positions on the Legislation in the 106th Congress . . . . . . . . . . 11
The Federal Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
The Treasury and Revenue Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
List of Figures
Figure 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Figure 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Figure 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Figure 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Figure 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Figure 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Figure 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Proposals to Allow Federal Reserve Banks
to Pay Interest on Reserve Balances:
The Issues Behind the Legislation
Introduction
The Federal Reserve Act of 1913, as amended, requires depository institutions
to maintain reserve balances at Federal Reserve Banks (the Fed).1 By this same law,
the Fed has not been allowed to pay interest to the depository institutions for these
balances. The Fed uses these reserve balances for two purposes: interbank
transactions (check clearing between depository institutions) and monetary policy
(increasing and decreasing the money supply and, thus, interest rates). For a variety
of reasons, including technological developments and Fed policy, depository
institutions’ reserve balances at the Fed have been declining, reaching a point that
raises concern by some banking analysts about short-term interest rate stability and
the Federal Reserve’s ability to conduct monetary policy. Required reserve balances
fell from almost $37 billion in 1988 to a little more than $4 billion in the first quarter
of 2000. These balances have risen to about $9 billion in last quarter of 2001.
Without sufficient reserve balances at the Fed, short term interest rates could
become more volatile and monetary policy could become operationally more difficult.
The link between these balances at the Fed and short-term interest rates is through the
federal funds market. Depository institutions trade their funds held at the Federal
Reserve among themselves every day at the interest rate called the federal funds rate.
Financial markets use the federal funds rate as a benchmark for most short-term
interest rates. A shortage of Fed balances could lead to higher rates in the federal
funds market. Furthermore, because these balances are used in open market
operations -- the buying and selling of government securities to expand and contract
the money supply -- a balance shortage at the Fed could limit the Fed’s ability to
conduct monetary policy. Normally, the Fed uses these account balances to debit and
credit the Fed accounts of the institutions that engaged in open market operations.
To induce depository institutions to maintain larger balances at the Fed,
legislation reported from committees in both the Senate and House would allow the
Fed to pay depository institutions interest on their balances at Federal Reserve Banks.
1 The Federal Reserve System consists of 12 regional banks and a Board of Governors in
Washington. See the CRS Electronic Briefing Book on Banking and Financial Services at
[http://www.congress.gov/brbk/html/ebfin1.html]. Depository institutions are commercial
banks, savings and loan associations, mutual savings banks and credit unions.

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This report presents some of the economic issues related to this proposed
remedy. The report begins with a brief discussion of the legislation itself. The
second section discusses the two main purposes of reserve balances at Federal
Reserve Banks. The third section analyzes the level of the various categories of
reserve balances at the Fed and trends in the amounts. The fourth section briefly
describes depository institutions’ reserve balance management. The fifth section
briefly explains what would be likely to happen if the Fed paid interest on reserve
balances. The sixth section presents the arguments the Fed uses in support of the
legislation in the earlier Congresses as well as the Department of the Treasury’s
arguments for not supporting it.
The Legislation
Legislation to allow the Federal Reserve Banks to pay depository institutions
interest on the reserve balances the depository institutions maintain with them has
been introduced in the 107th Congress.
The bills include S. 229, S. 524, S. 601, H.R.
974, and H.R.1009. On January 31, 2001, Senator Hagel introduced the Interest on
Business Checking Act of 2001 (S. 229) that deals with two regulatory relief issues.
First, S. 229 would allow payment of interest on checking accounts immediately after
enactment by allowing depository institutions to make almost daily transfers of funds
from checking accounts to interest-bearing accounts for two years following
enactment. In these two years, observers expect financial markets to adjust to paying
interest on checking accounts. At the end of the two years, S. 229 would repeal the
prohibition on paying interest on checking accounts. S. 229 would also allow Federal
Reserve Banks to pay interest on required reserve balances. On its introduction the
bill was referred to Committee on Banking, Housing, and Urban Affairs. On March
22, 2001, as similar bill, S.601, the Small Business Checking Regulatory Relief Act
of 2001was introduced by Senator Shelby and was also referred to the same
committee.
On March 31, Senator Schumer introduced the Small Business Interest Checking
Act of 2001, S. 524, which like S. 229 deals with paying interest on business checking
and interest on reserves at the Fed. In addition, S. 524 deals with the operational
arrangement issue of increasing the Fed’s flexibility in setting reserve requirements on
checking accounts to the point of possibly eliminating them. The major differences
between the two Senate bills are that the S. 229 would limit the Fed to paying interest
on required reserve balances. By contrast, S.524 would authorize the Fed to pay
interest on all or any portion of reserve balances, as it sees fit. The other difference
is that S. 524 has a provision for financing the Fed’s interest payment to financial
institutions. Effectively, the government would pay the interest out of the amounts
the Federal Reserve Banks usually turn over to the U.S. Treasury.2 The bill was
referred to the Committee on Banking, Housing, and Urban Affairs.
2 For more detailed analyses of these provisions, see CRS Report RL30874, Proposal to
Allow Federal Reserve Banks to Pay Interest on Reserve Balances: The Issues Behind the
Legislation, by Walter W. Eubanks; CRS Report RL30816, Anticipated Effects of
Depository Institutions Paying Interest on Checking Accounts, by Walter W. Eubanks.

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There were two House bills in the 107th Congress dealing with these issues – the
Small Business Interest Checking Act of 2001 (H.R. 974) introduced by
Representative Kelly (this bill is similar to S. 524), and the Business Checking
Freedom Act of 2001 (H.R. 1009) introduced by Representative Toomey. H.R. 1009
was incorporated in H.R. 974, which was passed by the House on April 3, 2001 and
referred to the Senate Committee on Banking, Housing, and Urban Affairs on April
4, 2001. H.R. 974, as amended would end the prohibition against checking account
interest as of two years following enactment. As passed, H.R. 974 also authorizes the
Federal Reserve to pay interest on reserves, linking two forms of regulatory relief
together in a way favored by large banks.3 This kind of linkage prevented passage of
either form in the 106th Congress, according to industry followers.4 The Department
of the Treasury supports paying interest on checking accounts of businesses, but does
not support paying interest on reserve balances at the Fed. Similar legislation was
introduced in the 106th and 105th Congresses.
The Purposes of Federal Reserve Balances
The Federal Reserve System and depository institutions use reserve balances at
the Fed’s regional banks to facilitate essentially two functions: inter-depository-
institution check clearing, and monetary policy.
Facilitate Check Clearing
Depository institutions maintain reserve balances in the 12 Federal Reserve
Banks located around the country – in Atlanta, Minneapolis, New York, San
Francisco, and so on. Every depository institution is affiliated with the Bank in its
geographic region by maintaining an account balance, among other things, with that
regional Fed Bank. For a fee, the Fed provides the interbank service of collecting
checks and transferring funds to the various depository institutions accounts
throughout the system. The service allows banks to clear billions of checks across the
country with little disturbance to the day-to-day operations of depository institutions
and their customers. As an outgrowth of this process, depository institutions trade
their balances held at the Federal Reserve among themselves every day at the interest
rate called the federal funds rate. Using the Fed market, depository institutions
finding themselves with shortages of balances at the Fed may borrow from other
institutions with excess balances by paying the lending institutions the federal funds
rate for the funds to make up the shortfalls.
Facilitate Monetary Policy
The reserve balances that depository institutions maintain at the Fed enable the
Fed to influence strongly the amount of money in circulation through open market
3 U.S. Congress. House. Committee on Financial Services. Small Business Interest Checking
Act of 2001, Report to Accompany H.R. 974. 107th Congress, 1st session, H.Rept. 107-38.
4 Adam Wasch. Progress on Banking Measures Frozen as Congress Weighs Lame-Duck
Session. BNA’s Banking Report, November 6, 2000, pp. 578-579.

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operations. Open market operations are the buying and selling of U.S. government
securities, including federal agency securities, to all investors. Through these
operations, the Fed may, for example, reduce the money supply by selling investors
U.S. government securities and receiving money in exchange. On the other hand, by
buying securities the Fed takes in securities and gives depository institutions money
in exchange to expand the money supply. The accounts of the depository institutions
involved in these open market operations are credited or debited by the Fed. Open
market operations, through reserve balances at the Fed, are a smooth, efficient
method of influencing the money supply.
The Level of Reserve Balances at the Fed
The reserve balances that a depository institution maintains at the Fed fall into
three categories: required reserves, required clearing reserves, and excess reserves.
The level of economic activity affects the level of these balances because they are
generally tied to the amount of economic transactions taking place in the economy.
More checks are written with higher levels of economic activity.
Required Reserves
The level of required reserves is based on the portion of the depository
institutions’ transaction deposit accounts that the Fed requires them to set aside. In
other words, the Fed requires depository institutions to set aside as required reserves
a certain fraction of the checking deposits they take in. Before 1959, the Federal
Reserve required that the amount set aside be kept at a regional Federal Reserve
Bank. Today, by Fed regulation, depository institutions have discretion in deciding
whether required reserves are kept in the form of vault cash at the institution or
balances at the Fed. Required reserves,
therefore, refer to designated reserve
Figure 1
balances held as vault cash and as
Total Required Reserves
deposits at the Fed.5
(1980:Q1 -- 2001:Q4), in $ millions
70000
It is also important to note that
only large depository institutions have
60000
to hold required reserves at the Fed.
50000
For smaller depository institutions,
40000
under current regulations, no reserves
30000
are required for reservable liabilities
20000
(i.e., transaction accounts) under $4.7
10000
80:Q1
84:Q1
88:Q1
92:Q1
96:Q1
00:Q1
million. Moreover, reservable
Source: Federal Reserve Board
liabilities between $4.7 and $47.8
million are subject to a minimal reserve
of 3%. This means that most small banks do not have to post any required reserves,
5 Note: Required reserves are not an emergency store of liquidity or capital requirements to
buffer against losses. However, since depository institutions have to maintain daily required
reserve balances on a 2-week-average basis, depositories may use required reserves in day-to-
day operations for other temporary transaction purposes and make adjustments later.

CRS-5
and, where they do, the requirements are met entirely with vault cash. Consequently,
the Federal Reserve Board has estimated that only the upper one fifth of depository
institutions would be directly affected by allowing the Fed to pay interest on reserve
balances held with them.6 Large depository institutions hold the lion’s share of
deposits in an increasingly concentrated sector.7
Total required reserve balances, the sum of balances held at the Fed and vault
cash at the institutions, are shown in Figure 1. The data in these figures are quarterly
averages. Note that the total required reserve balance is at about the same level as it
was in the 1980s, averaging about $40 billion. The concerns that brought about the
legislation in Congress are made clearer in examining the two components of required
reserves separately.
Reserve Balances at the Fed. Figure 2 clearly shows that required reserve
balances at the Fed have been declining. Required reserve balances fell from a high
of almost $37 billion in 1988 to less than $4 billion at the end of 1999. In 2000 the
level is now back to little less than $6 billion. The decline is partly attributable to
changes in Fed regulations and policies that were authorized by the Monetary Control
Act of 1980. The Fed quickly eliminated required reserves on savings accounts and
lowered those applicable to transaction accounts.8
In 1981, the Fed lowered reserve requirements further.9 It is difficult to
determine what part of the decline shown in Figure 2 beginning in 1980 was due to
the decline in economic activity and what part to the decline in reserve requirements.
6 Letter from Donald L. Kohn, Director of the Division of Monetary Affairs, Board of
Governors of the Federal Reserve System to William L. McQuillan, President of the
Independent Bankers Association of America in: U.S. Congress. House of Representatives.
H.R. 1585 –Depository Institution Regulatory Streamlining Act of 1999, Hearing before the
Subcommittee of Financial Institutions and Consumer Credit of the Committee on Banking
and Financial Services, 106th Congress, 1st session, May 12, 1999, p. 193.
7 As of August 2000, there were 8,518 commercial banks in the U. S.; the top 379 held 98%
of total deposits, according the Federal Deposit Insurance Corporation’s (FDIC) statistics.
8 See Joshua N. Feinman, Reserve Requirements: History, Current Practice, and Potential
Reform, Federal Reserve Bulletin, June 1993: pp. 578, 580-81.
9 See Federal Reserve Bulletin, March 1981, pp. 247-249.

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But in 1991, when another
Figure 2
reduction in requirements
occurred, the decline in
Required Reserve Balances at the Fed
balances was dramatic, with
(1980:Q1 -- 2001:Q4), in $ millions
almost a $12 billion drop in
40000
one quarter. Required
reserves at the Fed began to
30000
decline further in 1994 when
the Fed allowed retail sweep
20000
accounts. Retail sweep
accounts are accounts on
10000
which depository institutions
use computer programs to
t r a n s f e r c u s t o m e r s ’
0
80:Q1 83:Q1 86:Q1 89:Q1 92:Q1 95:Q1 98:Q1 01:Q1
transaction deposits (checking
Sources: Federal Reserve Board
deposits), which are subject to
reserve requirements, temporarily into savings accounts, which are non-reservable
accounts.
The required reserve balances at the Fed are regulated by a flexible process. By
Fed regulation, depository institutions must maintain only an average required reserve
balance over a two-week period. Thus, depository institutions have the flexibility of
adjusting the daily balances they hold for this purpose. For example, a depository
institution caught in an emergency demand for cash could actually convert its required
or other balances into cash without any penalties within this two-week period. Later
in the period, the institution must maintain above average balances at the Fed to be
able to maintain the average reserve requirement over the two-week period.
Vault Cash. While required reserve balances at the Fed have declined, the
amount of required reserves that is held as vault cash has grown. In 1980 depository
institutions kept one third of their required reserves in the form of vault cash. With
Fed regulations and
policies permitting, by
Figure 3
2000, they kept between
78% and 85% of their
Vault Cash Balances
required reserves as vault
(1980:Q1--2001:Q4), in $ million
cash. It is important to
40000
make the distinction
between total vault cash
30000
and required reserves that
are held as cash. Figure 3
20000
shows only the required
reserve balances held as
10000
vault cash. Depository
institutions hold a larger
0
amount of vault cash than
80:Q1 84:Q1 88:Q1 92:Q1 96:Q1 00:Q1
needed for required reserve
Source: Federal Reserve Board
purposes. The main
determinant of vault cash,
however, is economic transactions.

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Neither vault cash nor reserve balances at the Fed pay any interest. But vault
cash is preferred to reserve balances at the Fed mainly because it offers more
flexibility. The growth in vault cash as a proportion of reserves is partly due to wider
use of automated teller machines (ATMs). From 1993 to the end of 1999, the number
of U.S. on-premise bank-owned ATMs grew from 70,000 to approximately110,000.10
Cash waiting to be withdrawn in an ATM either on-premise or off-premise is
considered vault cash. As a result, vault cash simultaneously provides depository
institutions fulfillment of their reserve requirements, and is available for precautionary
and transaction purposes. In contrast, its major disadvantages are that it does not
earn interest, it is not at the Fed for interbank check clearing purposes and it does not
facilitate the operations of monetary policy as such.
Required Clearing Reserves
Clearing balances were
Figure 4
established in the early 1980s to
Required Clearing Balances at the Fed
avoid overdraft penalties. They have
(1980:Q1 -- 2001:Q4), in $ millions
been a growing part of reserve
8000
balances at the Fed, totaling almost
$8 billion in the last quarter of 2001,
6000
but have slightly declined recently, as
shown in Figure 4. Clearing balances
4000
are voluntary, but, once they are
agreed to, they become required.
2000
Depository institutions may
voluntarily enter into an agreement
0
with the Fed to hold clearing
80:Q1 84:Q1 88:Q1 92:Q1 96:Q1 00:Q1
Source: Federal Reserve Board
balances at the Fed. Under this
agreement, depository institutions
commit in advance to holding a specified balance, above the normal required reserve
balances. “Required clearing balances provide a cushion against overnight
overdrafts.... If the depository institution fails to satisfy its required clearing balance,
the deficiency is subject to a charge.”11 Clearing balances, like required reserve
balances at the Fed, must be maintained on average, over the two-week reserve
maintenance period.12
To offset the cost (opportunity cost) of holding clearing balances, the Fed pays
the institutions a credit at approximately the federal funds rate. These credits can only
be used to defray Fed charges for services it provides, such as check clearing and wire
10 ATM Use Is Growing, But So Are Visits To The Teller, Bank Network News, Volume 18,
Number 23, April 27, 2000. p. 7.
11 See Cheryl L. Edwards, Federal Reserve Bulletin, November 1997: p.861.
12 See Statement of Laurence H. Meyer, Member, Board of Governors of the Federal Reserve
System, before the Committee of Banking and Financial Serves, United States House of
Representatives, May 3, 2000 [http://www.house.gov./banking/5300mey.htm].

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transfers.13 Depository institutions accumulate the credits when earnings on clearing
balances exceed Fed services used. Figure 4 shows that while clearing balances have
grown with economic transactions and are now greater than required reserve balances
held at the Fed (Figure 2), they have yet to reach the historic levels of required
reserves (Figure 1).
Excess Reserves
B e s i d e s r e q u i r e d
r e s e r v e s , d e p o s i t o r y
Figure 5
institutions voluntarily
Excess Reserve Balances at the Fed
maintain reserves at the Fed
(1980:Q1 -- 2001:Q4), in $ millions
in excess of required and
8000
clearing reserves. These
reserves, which are held
6000
mainly for precautionary
4000
purposes, are called excess
reserves. Excess reserves
2000
are generated by the
interbank payment process,
0
80:Q1
84:Q1
88:Q1
92:Q1
96:Q1
00:Q1
where the Fed serves as a
Sources: Federal Reserve Board
clearing house for banking
transactions and for which it
charges fees. Because of the dollar amount variations involved in the check clearing
reconciliation process, some analysts consider excess reserves as residuals that are
generated mainly by overshooting needed balances rather than a voluntary or a
required balance. The almost $6 billion spike in excess reserves in the third quarter
of 2001 was due to added liquidity the Federal Reserve provided depository
institutions in response to the 9/11attacks on New York and Washington.
Comparing Figure 1 to Figure 5 shows that the amount of excess reserve
balances held at the Fed is usually considerably smaller than required reserves. Excess
reserve balances depend mainly on the ebbs and flows of economic transactions.
Consequently, excess reserve balances tend to be subject to short term variations.
Even though there is an upward trend in excess reserves, the magnitude and growth
are not large enough to offset the decline in required reserves as shown in Figure 2.
The quarterly average excess reserve balance is less than a billion dollars in
comparison to the comparable average for required reserve balances of $23 billion
over the 1980–2000 period.
Reserve Balances at the Fed: a Summary
In sum, these three categories of reserve balances at the Fed -- required,
required clearing, and excess reserves -- totaled close to $14 billion in December
2000. That is less than half of what required reserve balances at the Fed were in
13 Ibid.

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1980, when the economy was much smaller. The long term decline in required
balances at the Fed has not been offset by the growing levels of the excess and
clearing balances. It is also clear from Figure 2 and the Fed data supporting Figure 2
that the decline in required reserves was caused in part by the Fed’s policy authorized
by Congress to reduce reserve requirements.
How Depository Institutions Manage Reserve
Balances
Managing a Single Deposit Account at the Fed
Under the present payment system, the management of reserve balances at
Federal Reserve Banks is a critical part of depository institutions’ overall asset and
liability strategic management. These balances, regardless of whether they are
required, excess, or held for clearing purposes, are held in an aggregated account at
the Federal Reserve Banks. At the Fed, there is basically one account per institution:
The deposit [balance] is neither a distinct type nor separate category of deposit: all
of the funds are available to settle interbank payments and may be converted to vault
cash if necessary.14 Since the balance in this account is used for many purposes, and
shortages expose the institution not only to costly penalties but also to failed
commercial transactions, a depository institution by necessity must manage its reserve
balances as part of its overall financial resources management.
The Profit Motive
Management of required reserve balances at the Fed is important to the
profitability of a depository institution. To illustrate one profit consideration,
depository institutions must maintain only an average required reserve balance over
a two-week period for required reserves and required clearing reserves, as described
earlier. Thus, depository institutions have the flexibility of adjusting the daily balances
they hold for these purposes. If the institution’s commercial and interbank clearing
needs exceed its balances at the Fed, it may use its required reserve balances at the
Fed to meet those needs without incurring any overdraft penalties within this two-
week period. In the period, the institution must maintain above-average balances at
the Fed in order to have the average reserve requirements over the two-week period.
These financial resources to meet required reserves at the Fed would otherwise have
been available for profitable investment opportunities. Although the institution
avoided penalties, it is likely to have suffered the cost of having forgone investment
opportunities.

Depository institutions seek to keep their reserve balances under their control
as much as possible in order to be able to maximize profits. Using December 2000
to illustrate, depository institutions’ required reserves totaled $41.1 billion.
Depository institutions met these requirements with $31.8 billion in vault cash (Figure
14 See Anderson Richard G. and Robert N. Rasche. p. 6.

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3) and $8.7 billion in required reserve balances at Federal Reserve Banks. Depository
institutions held only $1.5 billion in excess reserves and $16.6 billion in clearing
balances at the Fed. The bulk of the required reserves is under the direct control of
depository institutions’ management, not the Fed. In contrast, before 1959, all
required reserves were held at the Fed. Allowing depository institutions to keep a
part of their required reserves as vault cash allows them to find the optimum
commercial use of these funds, while meeting their reserve requirements. The idle
reserve (earning no interest) balances at the Fed are clearly being minimized.
The Danger of Relying Too Heavily on Vault Cash
Depository institutions’ strategy of holding on to required balances has its
dangers. For example, the Fed strongly discourages overnight overdrafts, with hefty
fees among other penalties.15 In the 1980s, right after the Fed lowered reserve
requirements, some depository institutions had difficulty managing their reserve
balances at the Fed. They were relying heavily on vault cash to meet their required
reserves and lacked reserves at the Fed to clear their interbank transactions. Some
institutions found overdrafts of their Fed accounts, resulting in a large number of
penalties, were a serious problem. Subsequently, required clearing reserve balances
were established.
Again, in early 1991, the requirements were abruptly lowered, which caused
extreme volatility in short-term interest rates. This volatility was evident, “when the
federal funds rate daily trading range averaged around 8 percentage points compared
with about 1.5 percentage points in normal times.”16 The Fed attributed this volatility
to the fact many depository institutions’ reserve balances at the Fed fell below the
level they needed to hold against overdrafts. Since there were lower balances, the
base was smaller than normal. This caused the price to rise more than normal. The
price and quantity effect are shown in Figures 2 and 6. There was a drop in required
reserve balances of almost $12 billion in the first quarter of 1991(see Figure 2) and
a rise in the federal funds rate to almost 11% (see Figure 6).
If the Fed Pays Interest on Reserve Balances
Critical factors in determining the financial impact of the Fed paying interest to
depository institutions are the interest rate paid relative to prevailing rates and the
size of reserve balances on which it will be paid. According to Federal Reserve
Governor Laurence H. Meyer in testimony before the House Banking Committee, the
Fed intends to pay a rate below the federal funds rate on required reserve balances.
15 Required reserve deficiencies are subject to a significant penalty rate at the Fed discount
window and “administrative counseling” or a penalty federal funds rate. See Richard G.
Anderson and Robert N. Rasche, Measuring the Adjusted Monetary Base in an Era of
Financial Change, Federal Reserve Bank of St. Louis, November/December 1996: p. 6.
16 See Joshua N. Feinman, Federal Reserve Bulletin, June 1993: p. 582.

CRS-11
If the bill becomes law, the Federal Reserve would likely pay an interest
rate on required reserve balances close to the rate on other risk-free
money market instruments, such as repurchase agreements. This rate is
usually a little less that the interest rate on federal funds transactions,
which are uncollateralized overnight loans of reserves in the interbank
market.17
Since most interest rates are above the federal funds rate, depository institutions are
not expected to significantly shift their financial resources to take advantage of this
rate.
Most financial analysts expect depository institutions will shift their required
reserves from vault cash to balances at the Fed. Vault cash is a non-income-earning
asset that is a component of required reserves and can be easily shifted to Fed
balances.
The legislation before Congress would permit the Fed to pay interest on all or
specific types of balances if it sees fit. Payment of interest on total reserves at the Fed
might be administratively the simplest and least costly approach. It would be least
costly because it would minimize the incentives for depository institutions to shift
reserve balances among the various types of reserves.18
As earnings to depository institutions, the interest payments could increase
profits as the cost of offering transaction deposit accounts would be reduced. In a
competitive environment, however, the depository institutions would likely pass the
increase in earnings onto their consumers, leaving their profits unchanged. Sweep
accounts will be reduced, but the remaining ones are expected to be profitable for
depository institutions. The sweep accounts that would be eliminated would become
reservable accounts and, thus, a source of reserve balances at the Fed.
In sum, it is reasonable to expect depository institutions to maintain higher
balances at the Fed with most of these balances coming from idle vault cash, but some
additional balances at the Fed might come from a reduction of sweep accounts.
Two Agencies’ Positions on the Legislation in the
106th Congress
The Federal Reserve
The Fed has supports legislation that would allow it to pay interest on reserves
depository institutions maintained at its banks. The Federal Reserve supported similar
legislation in the 106th and the 105th Congresses. The Federal Reserve made the
17 Meyer testimony before House Committee on Banking and Financial Services, May 3,
2000, Op. Cit.
18 From the perspective of a depository institution, this shifting of balances would create
inefficiencies as the shifting tends to increase the risk of shortages of specific balances.

CRS-12
argument that the legislation would help to improve economic efficiency by enhancing
the operation of monetary policy and making the banking industry more competitive
with non-depository financial intermediaries.19 Economic efficiency would be
improved because earning interest on reserve balances would reduce the depository
institutions’ cost of doing their business as financial intermediaries. These institutions
have long argued that forgone earnings on Fed balances put them at a competitive
disadvantage relative to non-depository competitors. For example, securities and
other competing firms offer transaction accounts through higher-earning money
market mutual funds and Eurodollar deposits than depository institutions can offer.
To reduce the cost of offering their customers similar products, depository
institutions must have incurred the cost of developing and maintaining the technology
to do daily sweeps of transaction accounts. The resources used in maintaining these
accounts would now be available to engage in more productive activities.
The Fed also points out that the cost of paying interest on reserve balances is
relatively small when compared to the Federal Reserve System’s deposits to the U.S.
Treasury.20 The Congressional Budget Office (CBO) and the Office of Management
and Budget (OMB) estimate that to pay interest on required reserve balances will cost
between $600 and $700 million over 5 years. CBO recognizes in its estimate that
with the expected larger balances at the Fed, the Fed may invest them in higher-
earning government securities. Potentially, the return from these government
securities offset the $600 to $700 million the Fed paid to attract these balances.21 In
other words, the difference in the interest paid to attract the additional reserve
balances and what the Fed would earn on its investments might result in a net gain for
the Treasury.22 This gain would still be small compared to the annual Federal Reserve
Treasury Deposits shown in Figure 7, estimated to total almost $25.6 billion in fiscal
year 2002.
Eliminating potential interest rate volatility23 is an argument the Fed used in
support of S. 576 and H.R. 4209 in the 106th Congress. The evidence in support of
this argument was the federal funds rate volatility in early 1991, when the federal
funds rate daily trading range averaged around 8 percentage points compared with
about 1.5 percentage points in normal times.24 The Fed attributes this volatility to the
19 Ibid.
20 These are Fed receipts paid to the Treasury. They are sometimes confused with the Fed
surpluses, which are the retained earnings of the Federal Reserve System that are kept on hand
and which are equal to its paid in capital.
21 U.S. Congress, Senate Committee on Banking, Housing, and Urban Affairs. Financial
Regulatory Relief and Economic Efficiency Act of 1999, report to accompany S. 576,106th
Cong., 1st sess., S. Rept. 106-11 (Washington: GPO, 1999).
22 If the additional balances come from vault cash, gain to the Treasury would be less certain,
at least from a social welfare point of view, where vault cash would be available for use for
any purpose.
23 See CRS Report 98-416 E, Payment of Interest by the Federal Reserve to Depository
Institutions: An Analysis, by G. Thomas Woodward.
24 Figure 6 shows that the average daily federal funds rate for the year. A high variance of 8%
(continued...)

CRS-13
fact that in 1991 many depository institutions’ reserve balances at the Fed fell below
the level they needed to hold. Overdrafts occurred massively, causing the fed funds
rate to rise rapidly. While the rationale for the 1991 episode remains true, the data
shown in Figure 6 suggest that the Fed and depository institutions were able to make
the necessary adjustments to prevent such volatility from recurring for the rest of the
year. The rapid rise in the federal funds rate occurred in late January 1991. A chart
of the daily federal funds rate since 1991 would show no other such episodes. This
suggests that the Fed and the depository institutions have been able to manage
interbank transactions and monetary policy without widespread volatility in interest
rates in general, despite the continued decline in reserve balances at the Fed.

Improvements in reserve balance
Figure 6
management might explain why there
has been little evidence of interest rates
volatility and monetary policy
ineffectiveness. Both the Federal
Reserve System and the depository
institution sector have developed
technology, reserves and cash
management strategies, and procedures
that have helped to improve interest
rate stability and monetary policy
effectiveness. Specifically: (1) the Fed
has made enormous steps in improving
the timeliness of providing account information to depository institutions, (2) more
frequent open market operations are increasingly geared to daily payment needs, (3)
a shift to lagged reserve requirements gives depositories and the Fed reserve advance
information on the demand for reserves, (4) improved procedures allow estimating
reserve demand, and (5) since 1994, the Fed has allowed depository institutions to
sweep transaction accounts to help reduce reserve balances.25 All these factors,
which are within the existing regulatory authority of the Fed, have helped to reduce
the need for larger reserve balances at the Fed.
The Treasury and Revenue Losses
As in the past last three Congresses, the Department of the Treasury has
consistently refused to support legislation that would allow the Federal Reserve to pay
depository institutions interest on Fed balances. The main reason for Treasury’s
position has been that paying interest on reserves is very likely to reduce revenues it
receives in the form of Federal Reserve Treasury Deposits. These deposits are
24 (...continued)
cannot be observed. The overall annual variance for 1991 was also lower than 1.5 percentage
points for the year. In fact, it was .74 percentage point.
25 Statement of Laurence H. Meyer, member, Board of Governors of the Federal Reserve
System, before the Committee of Banking and Financial Serves, United States House of
Representatives, May 3, 2000 [http://www.house.gov/banking/5300mey.htm].

CRS-14
earnings by the Federal Reserve System. It is estimated that for fiscal year 2002 the
Federal Reserve Treasury Deposits will be almost $25.6 billion (see Figure 7). The
Treasury and CBO conclude that this legislation will reduce federal revenues.
In the 105th and the
Figure 7
1 0 6 t h C o n g r e s s e s ,
Treasury’s position has
Federal Reserve Treasury Deposits
been that, if the Fed pays
(FY1980-FY2002), in $ millions
interest on reserve
35000
balances, that would
30000
shift revenues from the
25000
taxpayers to the banking
20000
industry. In the 105th
15000
Congress, when the
10000
federal budget surplus
5000
w a s l e s s c e r t a i n ,
0198019821984198619881990199219941996199820002002
Treasury also argued
Source: U.S. Gov't. Budget FY2003
that there were many
high priority claims on
scarce federal budget resources and there was a failure to identify an acceptable offset
to loss of these revenues.26 In the 106th Congress, Treasury did not support H.R.
4209 for similar reasons. Treasury, speaking for the Administration, pointed out that
paying interest on just the required reserve balances would cost the Treasury between
$600 and $700 million over 5 years.27 At the time required reserve balances had fallen
to about $5 billion.
The most of the bills in the 107th Congress would authorize interest on required
reserve balances only, and since required reserve balances at the Fed have risen about
to about $9 billion at the end of 2001, the CBO and OMB estimates are likely to be
valid for most of these bills. However, the CBO estimate was stated differently in its
April 3, 2001 cost estimate of H.R. 974. The estimate was that the bill would not
have any net effect on annual revenues over the 2002-2006 period, but would
decrease revenues after 2006. That revenue loss would total approximately $1.2
billion over the 2006-2011 period. On the other hand, if the Fed had to pay interest
on all the reserves it holds for depository institutions, the budgetary impact would be
greater than these estimates. In December 2001, these reserves were twice as much
as required reserves, $18.6 billion and would grow as a result of paying interest on
them.

26 Statement of Richard S. Carnell, Treasury Assistant Secretary for Financial Institutions,
before the Subcommittee on Financial Institution and Consumer Credit, House Committee on
Banking and Financial Services, United States House of Representatives, July 16, 1998
[http://www.house.gov/banking/71698car.htm].
27 Statement of Gary Gensler, Treasury Under Secretary , before the House Banking and
Financial Services Committee, United States House of Representatives, May 3, 2000.
[http://www.house.gov./banking/5300gen.htm]. The CBO and OMB estimates that were
referred to in the statement also recognized the possibility of an increase in revenues.