By Dan Kervick
Frances Coppola has a very nice piece in Forbes that takes on some of the continuing confusion over commercial bank reserves, central bank payments of interest on reserves and the relationship of both to commercial bank lending. She concludes with a ringing rejection of the frequently voiced claims that the Fed’s policy of paying interest on reserves inhibits bank lending, and that high excess reserve levels are an indicator of sluggish bank lending or bank hoarding:
The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending. They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash). It would make no difference whatsoever to their ability to lend. Only the Fed can reduce the amount of base money (cash + reserves) in circulation. While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.
Banks cannot and do not “lend out” reserves – or deposits, for that matter. And excess reserves cannot and do not “crowd out” lending. We are not “paying banks not to lend”. Positive interest on excess reserves exists because the banking system is forced to hold those reserves and pay the insurance fee for the associated deposits. It seems only reasonable that it should be paid to do so.
I wholeheartedly agree with the bottom line moral Coppola draws from the operational mechanics of bank lending, but I do think some additional clarity can be had on the question of whether or not commercial banks lend their reserves. And I also have some reservations about the justification Coppola cites for the policy of paying interest on reserves in the first place.