February 18, 2013 4:54 pm

Fears at Fed of rate payouts to banks

By Robin Harding in Washington and Tom Braithwaite in New York

©Bloomberg

US Federal Reserve officials fear a backlash from paying billions of dollars to commercial banks when the time comes to raise interest rates.

The growth of the Fed’s balance sheet means it could pay $50bn-$75bn a year in interest on bank reserves at the same time as it makes losses and has to stop sending money to the Treasury.

Officials at the US central bank fear it could create a public-relations nightmare after the Fed was lambasted for rescuing banks during the financial crisis. It is one factor prompting some inside the Fed to reconsider the eventual “exit strategy” from easy monetary policy.

In an interview with the Financial Times, James Bullard, president of the St Louis Fed, said: “If you think of the profitability of the biggest banks, if you’re going to talk about paying them something of the order of $50bn – well that’s more than the entire profits of the largest banks.”

Mr Bullard said that neither interest paid to banks nor possible losses on exit made any difference to the substance of monetary policy.

“I think it’s more just a question of the optics, and how you’re going to play the optics,” he added, referring to the perception of losses by the central bank. “And since it shouldn’t matter in a monetary policy sense you might as well play the optics in a better way than the one we’ve got planned.”

All banks hold reserves at the Fed. The central bank has boosted its balance sheet to more than $3tn as it buys assets to drive down long-term interest rates through its programme of quantitative easing.

It pays for the assets by creating bank reserves, which now amount to more than $1.6tn. The Fed could add another $1tn if it keeps buying assets for another year.

At the moment it only pays 0.25 per cent interest on those reserves. But according to its exit strategy, published in June 2011, the Fed plans to raise interest rates before it sells assets. Interest of 2 per cent on $2.5tn of reserves would run to $50bn a year.

That interest should not turn into profits for the banks. They will have to pass the revenues on by paying more interest to their depositors. But it could still add to a populist backlash in recent years against the Fed and the big banks.

One possible answer to the Fed’s larger balance sheet is to sell assets earlier in the exit process. Mr Bullard said that the Fed could consider creating accounting reserves now for any losses it expects in the future.

The Fed remits all of its earnings to the Treasury and has paid across $291bn in the last four years. But some of those gains will be reversed when it sells assets bought at today’s low interest rates at a time when rates are higher.

One banker argued that was the real danger. “It’s a little bit worrying for the politicians to get addicted to that level of income. The windfall profit has been a stunning number – that will go away over time.”

Bankers also noted that the exit strategy was uncertain and the Fed could increase interest rates on excess reserves more slowly than benchmark rates. They added that more reserves should be shifted out of the Fed and lent out as the economy improves.

Still, the eventual tightening could lead to substantial amounts being transferred to commercial banks from the Fed, given the amounts of cash they have parked there.Wells Fargo has $97.1bn sitting at the Fed, the largest amount of any bank, ahead ofJPMorgan Chase at $88.6bn and Goldman Sachs at $58.7bn, according to an FT analysis of SNL data.

Foreign banks also have a striking amount of cash at the Fed, potentially aggravating the Fed’s PR problem. Analysts at Stone & McCarthy noted recently that there had been a steep increase in foreign banks placing reserves at the Fed and suggested that “US banks may have distaste for the opportunistic arbitrage”, between lower market rates and the interest on reserves, whereas overseas institutions “might not feel encumbered in the same fashion”.

Canada’s TD Bank, Germany’s Deutsche Bank and Switzerland’s UBS each have more than $12bn at the Fed.

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