Laws 12 USC 461 et seq., Federal Reserve System, Bank Reserves

Regulations 12 CFR 204, Reserve Requirements of Depository Institutions

Additional Resources CUNA E-Guide: Reserve Requirements (Regulation D) Reserve Requirements: FAQs Transaction Limitations Chart

Related Links 2018 Adjustments for Calculating Reserve Requirement Federal Reserve Form FR 2900 Federal Reserve Form FR 2910a Federal Reserve System Reporting and Reserves Website FRB Services – Reserve Maintenance Manual Guidance on Retail Deposit Sweep Accounts Payment of Interest on Balances

Under the Emergency Economic Stabilization Act of 2008, Federal Reserve Banks will pay interest on balances held at Reserve Banks to satisfy reserve requirements and on balances held in excess of required reserve balances and clearing balances starting on October 9, 2008.

How does this affect credit unions?

Under Regulation D ("Reg D") credit unions are required to maintain certain levels of reserves in the form of cash, deposits at the Federal Reserve Bank ("Fed"), or in a 'pass through account'. The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008. On October 6, 2008, the Fed announced in Monetary Policy Announcement 20081006a that effective October 9th, interest would be paid on reserve and excess reserve balances at the Fed and outlined the process.

This will require that credit unions with these balances consider the income being provided in their Asset-Liability Management Programs and other income related processes.

I. Background

Section 128 of the Emergency Economic Stabilization Act of 2008, enacted on October 3, 2008 (the “2008 Act”), accelerated the effective date of the authority for the Federal Reserve Banks to pay earnings on balances maintained at the Reserve Banks by or on behalf of depository institutions. The 2008 Act made this authority effective on October 1, 2008. This authority was originally enacted in the Financial Services Regulatory Relief Act of 2006 (the “2006 Act”) with an original effective date of October 1, 2011. The 2006 Act provides that such earnings must be paid at least once each quarter at a rate not to exceed the general level of short-term interest rates. The 2006 Act also provides that the Board may prescribe regulations concerning the payment of earnings, the distribution of earnings to the depository institutions that maintain balances or on whose behalf balances are maintained, and the responsibilities of correspondents to distribute and credit earnings on balances maintained by the respondent on a pass-through basis with the correspondent.

 

The Federal Reserve Banks will pay interest on balances held at Reserve Banks to satisfy reserve requirements (“required reserve balances”) and balances held in excess of required reserve balances and clearing balances (“excess balances”). Reserve Banks will not pay explicit interest on clearing balances (balances that an institution holds to satisfy a contractual clearing balance agreement). Clearing balances will, however, continue to earn earnings credits under the existing clearing balance policy, although the Board has made minor adjustments to the calculations of earnings credits and float costs to be recovered that are related to reserve requirements. In addition, transitional adjustments for reserve requirements in the event of a merger or consolidation have been eliminated.

In the past, the absence of interest payments on required reserve balances acted as a tax on depository institutions’ issuance of deposits subject to reserve requirements. To the extent that depository institutions could not satisfy reserve requirements with vault cash, they were required to hold more balances than they otherwise would in a non-interest-bearing account at a Reserve Bank. The absence of interest on excess balances has meant that, when reserve supply significantly exceeds demand, the federal funds rate can fall to as low as zero.

The ability to pay interest on balances held at Reserve Banks should help promote efficiency and stability in the banking sector. Paying interest on excess balances will permit the Federal Reserve to expand its balance sheet as necessary to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability. Paying interest on excess balances should also help to establish a lower bound on the federal funds rate. Eligible institutions (defined below) will presumably be unwilling to lend balances in the funds market at a rate much below that paid on excess balances maintained at a Reserve Bank. In addition, paying interest on required reserve balances will eliminate much of the reserve tax and lessen the incentive for depository institutions to engage in reserve avoidance behavior, which absorbs real resources and diminishes the efficiency of the banking system.

In light of the current severe strains in financial markets, the amendments to Regulation D will be effective on Thursday, October 9, 2008. Interest will be calculated beginning with the biweekly reserve maintenance period ending October 22, 2008, and the weekly reserve maintenance period ending October 15, 2008. Interest payments will occur within the existing framework for reserve computation and maintenance, which includes reserve averaging, carryover provisions, and reserve deficiency charges. For both excess balances and required reserve balances, interest will be paid on these balances averaged over the reserve maintenance period. This approach is consistent with the current reserves framework under which compliance with reserve requirements is measured over either a seven-day or a fourteen-day reserve maintenance period, depending generally on the size of the institution. Interest will be credited 15 days after the close of the maintenance period in order to apply reserve carryover provisions.

 

II. Discussion

1. Eligible institutions
   
   The Act permits Federal Reserve Banks to pay interest on balances held by or on behalf of “depository institutions.” The Act’s definition of “depository institution” has a broader meaning than the definition of that term in section 19(b)(1)(A) of the Federal Reserve Act and Regulation D. To avoid confusion, the Board’s rule uses the term “eligible institution” to refer to those institutions included in the 2008 Act’s broader definition of “depository institution.” Therefore, the definition of “eligible institution” includes the depository institutions defined in the Federal Reserve Act, including banks, savings associations, savings banks and credit unions that are federally insured or eligible to apply for federal insurance.
    
2. Rate
   
   Interest will be paid on average required reserve balances and average excess balances maintained over a reserve maintenance period. The Board has established the initial rate of interest for required reserve balances to be the average targeted federal funds rate over the reserve maintenance period less 10 basis points. Setting this rate below the targeted federal funds rate reflects the fact that federal funds loans are uncollateralized and carry some counterparty risk, whereas deposits at the Federal Reserve Banks are free from such risk. Therefore, establishing some spread below the funds rate reflects the risk-free nature of a deposit at the central bank. The choice of 10 basis points is approximately equal to the average spread between the overnight rate on repurchase agreements secured by general Treasury collateral and the overnight rate on federal funds in recent years but prior to the onset of the current financial turmoil.
   
   The rate of interest for excess balances will be the lowest targeted federal funds rate during the reserve maintenance period less 75 basis points.
   
3. Treatment of correspondent balances
   
   Correspondents provide various services to respondent institutions, such as check and cash services. Under the Federal Reserve Act and Regulation D, certain respondents may elect to pass their required reserve balances through their correspondents to the Federal Reserve Banks for the purposes of satisfying reserve requirements, rather than holding balances directly with a Reserve Bank. A pass-through correspondent is responsible for holding sufficient balances in its account at the Reserve Bank to satisfy its own required reserve balance, its own clearing balance, and the aggregate required reserve balances of its respondents. In addition, certain institutions may act as pass-through correspondents under the Federal Reserve Act and Regulation D even though they are not themselves “eligible institutions”.
   
   The Reserve Banks will pay interest on required reserve balances maintained by or on behalf of an eligible institution, even if the pass-through correspondent for the eligible institution is itself not an eligible institution. In the case of a pass-through correspondent that is not an eligible institution, the required reserve balances held in the correspondent’s account will be solely those held to meet its respondent’s reserve requirements. Where the pass-through correspondent is an eligible institution, the required reserve balances in the correspondent’s account may include those balances held by the correspondent to meet its own reserve requirement, if any, as well as those held to meet its respondent’s reserve requirements.
   
   The rule also provides that the Reserve Banks will pay interest on excess balances held by or on behalf of eligible institutions, even if the pass-through correspondent for the eligible institution is itself not an eligible institution but has excess balances in its account.
   Without imposing additional reporting or accounting requirements, Reserve Banks cannot determine whether all or part of the excess balances in a pass-through correspondent’s account at a Reserve Bank are held on behalf of respondents. In light of this problem, and in order to avoid imposing additional reporting or accounting burdens, all of the excess balances held in the account of a pass-through correspondent that is not an eligible institution to be held on behalf of that correspondent’s respondents. Accordingly, all interest received on excess balances by such pass-through correspondents are attributable solely to the excess balances of their respondents. This provision enables pass-through correspondents and respondents to continue to negotiate the structure of their contractual relationships with maximum flexibility, including negotiations regarding the appropriate distribution of earnings received on behalf of respondent balances.
   
   Passing back of interest to respondents. The rule provides that a pass-through correspondent may pass back to its respondent the interest paid on balances held on behalf of that respondent, but it is not required to do so. Permitting, but not requiring, the pass-back of interest earnings is consistent with the treatment of reserve deficiency charges in Regulation D. The Reserve Bank assesses a deficiency charge to the account of the pass-through correspondent for any deficiency in its account balances, even if the deficiency is attributable to a respondent. It is left to the pass-through correspondent to determine whether to assess a deficiency charge on the respondent, or whether to make any adjustments in other aspects of the correspondent-respondent relationship to deal with attribution of deficiency and other charges.
   
   This approach also avoids interfering with existing arrangements between pass-through correspondents and respondents for services, including sweep arrangements or compensating balance requirements. Correspondent banks typically structure their respondent relationships in myriad ways, depending on a number of factors, such as services provided or balances held. Respondents may adjust the level of balances held with a correspondent in response to changes in the rates paid to them or other factors. Respondents that are not satisfied with their existing arrangements with a correspondent may take steps to renegotiate the terms of the relationship or even seek another correspondent.
   
   Exemption from Regulation Q.
   
   Some credit unions are subject to statutory and regulatory prohibitions against payment of interest on demand deposits. The 2006 Act, however, expressly authorizes the Board to prescribe regulations to allow pass-through correspondents to pass interest back to respondents even though the payment of interest on demand deposit accounts is still otherwise prohibited. The rule states that when a pass-through correspondent passes back to its respondent interest paid on balances held on behalf of that respondent, such a payment is not a payment of interest on a demand deposit for purposes of Regulation Q.
    
4. Transitional adjustments in mergers
   
   Provisions in Regulation D relating to merger-related adjustments to reserve requirements have been eliminated.
   
5. Clearing balance policy adjustments
   
   Clearing balances provide a way for depository institutions to hold additional balances at the Reserve Banks to meet their clearing needs. These balances currently earn implicit interest in the form of earnings credits used to cover the cost of Federal Reserve priced services.
   
   In light of the revisions to Regulation D, there are two related changes to the method in which earnings credits are calculated, along with a similar change to the method in which float costs to be recovered are computed. These changes discontinue practices related to reserve requirements that are no longer necessary.
   
   
   1. The first earnings credit adjustment, called the “imputed reserve requirement adjustment,” imputes a marginal reserve requirement ratio of 10 percent to the Reserve Banks because a private-sector correspondent would be required to hold reserves against a respondent’s balance. If the correspondent had a marginal reserve requirement ratio of 10 percent, then it would grant credits to the respondent based on only 90 percent of the respondent’s balance because it would have to hold the remaining 10 percent in the form of non-interest-earning reserves. This adjustment was eliminated because the reserves on the respondent’s balance would now earn interest at the rate on required reserve balances.
       
   2. The second earnings credit adjustment, called the “marginal reserve requirement adjustment,” adjusts for the fact that the respondent could deduct the balance held at a correspondent, but not at the Reserve Bank, from its reservable liabilities. The reserve requirement reduction is equal to the respondent’s marginal reserve requirement ratio multiplied by the balance at the correspondent. This reduction has value to the respondent when it frees up balances that can be invested in interest-bearing instruments, such as a federal funds loan. This adjustment has been eliminated because the respondent will now be indifferent between holding balances at the Reserve Bank, and earning the rate on required reserves, or maintaining the balance at a private-sector correspondent, taking the due from deduction, and investing those funds.
       
   The imputed reserve requirement adjustment and adjustment for cash items in the process of collection that is applied when measuring float costs to be recovered by Federal Reserve priced services have also been eliminated.
   
6. The Reserve Banks are now required to recover 100 percent of float costs. Previously, floats costs recovered by priced services were reduced by 10 percent. The adjustment imputed a reserve requirement to the Reserve Bank, but it also allowed the Reserve Banks to adjust the imputed required reserves by the adjustment for cash items. This approach mirrored that of a private-sector correspondent. There is no longer a need to impute a reserve requirement to the Reserve Banks because the private-sector correspondent will now earn interest on its required reserve balance. As a result, the Reserve Banks are no longer entitled to an adjustment for cash items.