FROM THE OFFICE OF PUBLIC AFFAIRS

Chairman Leach, Mr. LaFalce, and Members of the Committee, I appreciate this opportunity to present the Administration's views on H.R. 4209, the Bank Reserves Modernization Act of 2000, including the associated budget issues. H.R. 4209 would permit the payment of interest on reserve balances that banks maintain at the Federal Reserve. As we have testified in the past, while we appreciate a number of the reasons put forth in favor of the proposal, the Administration is unable to support this bill.

The Federal Reserve Act requires depository institutions to maintain reserves against certain of their deposit liabilities, in amounts prescribed by the Federal Reserve Board. The Federal Reserve has set reserve requirements above zero only against transaction accounts in excess of approximately $5 million. Thus less than one quarter of total deposit liabilities have reserve requirements. These reserve requirements are typically met by vault cash and some portion of an institution's reserve balances at a Federal Reserve Bank, known as required reserve balances. Reserve balances that depository institutions voluntarily hold above the amount necessary to meet reserve requirements are called excess reserves. Banks may also enter into agreements with the Federal Reserve to hold clearing balances in their reserve accounts in order to cover the transactions cleared through these accounts. These clearing balances do not count toward meeting reserve requirements.

Required reserve balances and excess reserves held at the Federal Reserve do not earn interest. They are therefore sometimes referred to as sterile reserves. Clearing balances earn implicit interest through the offset of fees for Federal Reserve services.

As of March 2000, depository institution reserve requirements totaled $38.5 billion. These requirements were met by $33.2 billion in vault cash and $5.3 billion in required reserve balances at Federal Reserve Banks. Banks also held $1.2 billion in excess reserves and $6.6 billion in clearing balances at the Federal Reserve.

Required reserve balances at the Federal Reserve Banks are now only 15 percent of their level at the end of the 1980s ($5.3 billion currently compared to $34.4 billion in December 1989). The decline may be explained primarily by three factors: (1) regulatory actions taken by the Federal Reserve in the early 1990s reducing reserve requirements, (2) banks' growing use of new products and technology, such as retail sweep accounts, to minimize required reserves, and (3) growth in the use of vault cash to meet reserve requirements, as increased ATM usage has increased the need for such cash. The proportion of reserve requirements met by vault cash rose from 44 percent in December 1989 to 86 percent in March 2000.

Proponents of paying interest on reserve balances have put forward three primary reasons, based on: (1) economic efficiency, (2) monetary policy, and (3) costs to the banking industry.

Economic Efficiency

Large banks have long offered "sweep" accounts to their commercial customers - arrangements whereby balances in corporate demand deposits are routinely swept into repurchase agreements, Eurodollar deposits, and money market funds until they are drawn down by the account holders. Although intended to put otherwise "idle" corporate balances to work (since these accounts are prohibited by law from earning interest), as a byproduct these arrangements also reduce the reservable deposit liabilities of banks. More recently, the declining cost of technology has allowed banks to establish new types of sweep arrangements for retail customer accounts with the express purpose of minimizing reserve requirements. This sweeping is often invisible to the customer as a practical matter.

Permitting the payment of interest on reserve balances might lead to greater economic efficiency. Banks have expended resources to avoid holding non-interest earning required reserve balances. If banks earned interest on these reserve balances, they would be less likely to expand the use of sweeps and might unwind some existing sweep programs. But the extent of efficiency gains for banks, their customers, and the economy is highly uncertain and cannot be readily estimated. Advances in technology have lowered the cost of sweep programs. How many sweeps would unwind would also depend on: (1) whether banks would be permitted to pay interest on business demand deposits, as H.R. 4067, recently passed by the House, would allow; (2) what customers would earn on their transaction accounts compared to sweep instruments; and (3) what banks would earn on reserve balances compared to alternative investments.

Some believe that the decline in required reserve balances would potentially lead to greater short-term interest rate volatility, although such volatility is not a serious problem at present. The smaller the amount of required reserves, the greater is the proportion of the demand for reserves determined by the more volatile daily clearing needs of banks relative to the pool of reserves that can meet this demand. As a consequence, the daily volatility in the federal funds rate - the short-term, operational target of monetary policy - could increase. The Federal Reserve believes that such volatility could impair its ability to target the federal funds rate as a means of implementing monetary policy. Payment of interest on reserve balances would give banks greater incentives to hold balances at the Federal Reserve. This in turn may lessen the potential volatility of the federal funds rate.

Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements. Securities firms and other competitors offer transaction services through money market mutual funds and similar arrangements. Others observe, though, that the forgone earnings that depository institutions currently incur through reserve requirements must be viewed in the context of their overall relationship to the federal government, including federal deposit insurance and access to the Federal Reserve payments system and discount window.

The Office of Management and Budget and Congressional Budget Office have estimated that paying interest on required reserve balances (together with permitting banks to pay interest on business demand deposits) would cost approximately $600 million to $700 million over 5 years. Both the OMB and CBO estimates take into account the effect on tax revenues from depository institutions that receive interest. In addition, both project that the proposal would result in higher reserve balances, which they estimate would generate some new earnings for the Federal Reserve and thus new Treasury receipts. Neither of these effects is enough to completely offset the revenue loss from the payment of interest.

Proponents of paying interest on reserve balances have put forth a number of reasons in its favor. As you will hear from the Federal Reserve, the ability to pay interest on these balances may improve the effectiveness of the tools that it has to implement monetary policy. The Federal Reserve and others have also suggested that financial system efficiency might improve as fewer resources would likely be devoted to minimizing reserve balances. As a matter of appropriate monetary control, paying interest on reserves might be a step in the right direction. However, the use of taxpayer resources in this regard is not contained in the President's Budget. Since paying interest on reserves would cost taxpayers $600 million to $700 million over 5 years, we strongly believe that this must not be done at the expense of other priorities.

Thank you for the opportunity to appear before the Committee. I am happy to respond to any questions.