40% Of The Fed's Interest On Excess Reserves Is Paid To Foreign Banks

Even as both the Fed and Wall Street are gripped by a raging debate over when, how and how much the Fed should shrink its balance sheet, most appear to be ignoring the $2.1 trillion elephant in the room: the fact that every incremental increase in the Fed Funds rate (also an increase in the Interest On Excess Reserves, or IOER, currently at 1.25%) is a handout to US commercial banks, but that the direct recipient of this explicit Fed subsidy are a substantial number of foreign banks.

Here are the numbers:

• as of the week of July 5, there were $2.1 trillion in reserves (of which the vast majority is "excess"), the largest liability by far on the Fed"s $4.5 trillion balance sheet (currency in circulation is the other major component and amounts to $1.5 trillion).


• as of the latest Fed rate hike, IOER is 1.25%

Putting these together, means that as of this moment, assuming no more rate changes, Janet Yellen will pay out $27 billion in interest on reserves parked with the Fed every year.

This much is known. What is less known, however, is the holding composition of these reserves, i.e., which banks have parked these $2.1 trillion in reserves with the Fed. Courtesy of the Fed"s H.8 statement, however, we can quickly figure out.

Recall that as we showed first all the way back in 2011, the total cash on the books of commercial banks with operations in the US tracks the Fed"s excess reserves almost dollar for dollar. More importantly, the number is broken down by small and large domestic banks, as well as international banks. It is the last number that is of biggest interest, because now that Congress is finally scrutinizing the $4.5 trillion elephant in the room, i.e., the Fed"s balance sheet, it may be interested to know that approximately 40%, or $838 billion as of the latest weekly data, in reserves parked at the Fed belongs to foreign banks.

While we will reserve judgment, and merely point out that of the $100 or so billion in dividends and buybacks announced by US banks after the latest stress test a substantial amount comes directly courtesy of the Fed - cash that ultimately ends up in shareholders" pockets - we will note that the interest the Fed pays to foreign banks operating in the US who have parked reserves at the Fed, amounts to $10.4 billion annualized as of this moment.

This is a subsidy from the Fed, supposedly an institution that exists for the benefit of the US population, going directly and without any frictions to foreign banks, who - just like in the US - then proceed to dividend and buybacks these funds, "returning" them to their own shareholders, most of whom are foreign individuals.

While the number appears modest, it is poised to grow substantially as the Fed Funds rate is expected to keep growing, ultimately hitting 3.0% according to the Fed.

Indicatively, assuming excess reserves remain unchanged for the next 2-3 years and rates rise to 3.0%, that would imply a total annual subsidy to commercial banks amounting to $65 billion, of which $25 billion would go to foreign banks every year.

We wonder if this is the main reason why the Fed is so desperate to trim its balance sheet as it hikes rates, as sooner or later, someone in Congress will figure this out.

And as a tangent: considering that cash at US banks, most of which is parked at the Fed as reserves, amounts to just under $1.5 trillion, we wonder why the Fed does not simply cut off foreign banks" eligibility for its generous IOER subsidy, and make its balance sheet eligible only to US banks. It would slash its bloated balance sheet by over $800 billion overnight. Oh yes, that may actually test the widely accepted theory that banks outside the US are "safe."

Is This Why The Fed Is Raising Rates???

Authored by Chris Hamilton via Econimica blog,

As the Fed is in the midst of a rate hike cycle, it seems important to remember why this cycle is like no previous rate hike cycle.  The mechanics of this hiking cycle are completely unique and experimental...thus the outcome is far more of an unknown than "normal".

Why?  In a typical cycle, the Fed would sell a relatively small portion of its assets...er, balance sheet (typically short duration bills and notes) to banks.  This would withdraw some of banks liquid funds (replacing them with less liquid assets) and create "tightness".  This tightness would push overnight lending rates higher and the daisy chain of rising rates would work its way through from the shortest eventually all the way to the 30yr Treasury bonds.

However, this time, nothing like that is happening.  This is because the Fed sold all its short term notes/bills (in Operation Twist) and bought longer duration MBS (mortgage backed securities) and longer duration Treasuries in Quantitative Easing to the tune of $4.5 trillion.  Further, since the Fed bought most of these assets from large banks, these banks held much of the proceeds from these sales at the FRB (Federal Reserve Bank).  For the Fed to perform typical rate hikes, it would need to remove most of the $2.1 trillion banks are now sitting on in excess reserves @ the FRB...likely creating a crisis in the process.  Conversely, if the Fed can"t contain the $2.1 trillion at the FRB, and the reserves are leveraged into the market...stand back in awe of the mother of all bubbles. 

Thus, the Fed has instead determined to raise rates via paying banks interest on these excess reserves to  maintain the reserves at the Federal Reserve.  In short, pay banks not to lend money, not to invest the reserves.  This is just like Federal programs that paid farmers not to farm...IOER (interest on excess reserves) pays big bankers not to bank.

Since the end of QE in late 2014, the Federal Reserve has continued to buy bonds with the intent of maintaining a consistent quantity of assets on its balance sheet.  But interestingly, banks excess reserves have been declining, by as much as $800 billion since late 2014 (chart below).  Apparently, during this Fed balance sheet maintenance phase (as the Fed continues to buy assets from the banks to maintain its balance sheet) banks aren"t doing their part and have been unwilling to retain these proceeds as excess reserves.

And a close up of the above chart from 2014 to present (chart below).  Since the end of QE, $800 billion previously held in excess reserves found its way into loans and/or markets!!!  Considering that much or even the majority of the excess reserves are held by foreign banks, it seems more likely the newly liberated cash would find its way into financial assets.  Even conservatively leveraged, that"s an awful lot of money (not so conservatively leveraged, it"s a big deal)!

Excess reserves held at the Fed declined by almost $800 billion from the end of QE until the Fed began it"s more recent set of rate hikes (from 0.5% to 1.25%)...but behold, excess reserves have responded by increasing almost $200 billion (chart below) since the recent set of rate hikes.

Excess reserves held at the FRB appear to have responded to the ramping IOER...just as the Fed intended (chart below)!?!

And paying those banks not to lend or invest those trillions of dollars is about to get very expensive...the 2018 number simply assumes the Fed gets all the way to 3% (potentially choking real world economic activity in order to pay banks to not blow the greatest bubble of all time?!?).  That would be $64 billion annually paid to the largest (primarily foreign) banks for doing nothing, taking no risks, and lending no money.

Otherwise, as the Fed continues reinvesting its maturing balance sheet, banks will continue to pour liquidity into the real world (primarily financial assets) rather than holding the proceeds at the FRB...pushing assets further into orbit. 

With an asset bubble already of epic proportions (detailed HERE and HERE), the only means to corral the excess reserves appears to be continually raising the federal funds rate (absent impact on the long end of the curve???) and continually paying the biggest banks more IOER"s not to lend money, paying the biggest banks billions more not to invest!?!

In a world where population and economic growth are slowing rapidly (detailed HERE and HERE and HERE), this appears to have been the Feds plan all along?!?