Board of Governors of the Federal Reserve System

August 26, 2019

Federal Funds Rate Control with Voluntary Reserve Targets

Garth Baughman¹ and Francesca Carapella

Since the financial crisis, the large quantity of reserves created under quantitative easing, combined with the framework employed by the Federal Reserve to implement monetary policy, has reduced banks' incentives to borrow from one another in the market for federal funds, reducing margins in this market. Even large loans, when extended only for short periods at small margins, deliver shockingly little profit. A one day loan of ten million dollars at a margin of ten basis points earns a net profit of only $27.78 = $10mil X (.001/360). Hence, when margins are small, potential earnings are insufficient for banks to maintain the infrastructure (credit agreements, trading staff, risk management, etc.) needed to lend, leading to a lack of participation in the market. Low participation may negatively impact competition and may potentially increase rate volatility. Reporting results from Baughman and Carapella (2019a), this note describes a framework for implementing monetary policy, dubbed a voluntary reserve targets framework, that could reintroduce significant margins in the federal funds market, reviving the market no matter the aggregate quantity of reserves, while simultaneously limiting the volatility of rates. Moreover, an active federal funds market may allow banks to operate with smaller liquidity buffers, so could reduce the steady state size of the Federal Reserve's balance sheet.

Floors

Since 2008, in the wake of quantitative easing, the Federal Reserve has implemented monetary policy through a floor system.² In this system, banks have an excess of reserves, and the Fed pays interest on those reserves at a rate termed the interest on excess reserves (IOER) rate. The large supply of reserves means that there are many potential lenders and few borrowers, pushing the federal funds rate--the rate at which banks and certain other institutions borrow and lend with each other--down close to the IOER rate (the "floor" below which banks are better off depositing with the Fed than lending). Hence, the Fed can change the federal funds rate simply by changing IOER. In a March 2019 statement, the Federal Open Market Committee (FOMC) reaffirmed its intentions to continue to implement monetary policy with this regime.

An important quirk of the federal funds market is the presence of participants not eligible to earn IOER, specifically several government sponsored entities such as the Federal Home Loan Banks (FHLBs, sometimes pronounced "flubs"). As described in a series of FEDS Notes by Stefan Gissler and Borghan Narajabad (see parts one, two, and three), because these institutions are not eligible to receive IOER, they lend any available reserves to banks who can earn IOER. These loans carry a higher rate than FHLBs funding costs, earning profit for the FHLBs, but a lower rate than IOER, so that the borrowing bank can deposit the funds at the Fed and earn a positive profit. Indeed, such trade has comprised the vast majority of volume in the federal funds market for nearly ten years, so the federal funds rate has printed somewhat below IOER for most of that time.

Since 2015, however, the Fed has been reducing the size of its balance sheet and, consequently, the quantity of reserves in the system. This tends to drive up the federal funds rate relative to IOER with more extreme trades and volatility as more banks find themselves, on occasion, short of reserves. To keep the federal funds rate within the target range set by the FOMC, the Fed has lowered IOER relative to the target range three times, starting June 13, 2018. Termed technical adjustments, the FOMC has moved IOER from equal to the top of the target range down to 15 basis points below the top of that range. With these technical adjustments, the FOMC has been able to maintain effective control over average rates, but the federal funds rate has become more volatile than it was prior to 2018. The next section describes a framework that might preclude the need for continued technical adjustments while also controlling volatility.

Voluntary Reserve Targets

An alternative to floors is a system of voluntary reserve targets (VRT). With a VRT system, the central bank asks banks to set a target for their reserve holdings. Then, the central bank pays a high rate on balances up to the target (targeted reserves), a lower rate on balances in excess of the target (excess reserves), and charges a fee for shortages relative to the target (reserve shortages). Instead of some fixed reserve requirement, each bank commits to a target for reserve balances that it can tailor to its own business model and current market conditions--such as announced changes in the Fed's balance sheet, seasonal factors, etc. Given targets, banks in excess of their targets earn a low rate from the central bank, and banks short of their targets face the prospect of paying fees. Hence, banks on either side of their targets could do better if they were to trade at an intermediate rate; VRT gives an incentive for market activity not present under a floor system. Further, interbank rates should be bounded above by the fee on shortages and below by the rate on excess reserves, just like the old US system where rates were, largely, bounded below by zero and above by the rate at which the Fed would lend (that is, the discount rate).

But what targets will banks set? If all banks were to set very low targets, they would all end up with reserves in excess of their targets and would earn the low excess rate, just like a floor system. They could have done better by setting higher targets. If all banks set high targets, they would all end up short of their targets and would face fees. They could have done better by setting lower targets. Indeed, the optimal strategy for a bank is to set its target exactly equal to the quantity of reserves it expects to have. Hence, as all banks set their targets equal to their expected quantity of reserves, aggregate targets should equal expected aggregate reserves.

That targets follow the expected quantity of reserves is the magic of a VRT. If reserves are expected to be scarce, banks will lower their targets reducing the scarcity. If reserves are expected to be abundant, banks will raise their targets reducing the abundance. In either case, the expected imbalance is preempted by the movement of banks' targets. A VRT system is self-stabilizing.

Individual banks, of course, might make forecasting errors when setting their targets. For example, a bank may receive an unexpected deposit or be asked to make a payment that can put a bank over or under its target. This case, however, reveals another self-stabilizing feature of a VRT. An unexpected withdrawal from one bank in the form of an electronic payment or wire transfer is, for the receiving bank, a deposit. So, if the sending bank is in shortage, there is a natural partner in excess--the bank who received the transfer. VRT tends to result in a well balanced market with approximately equal funds on each side of the market, so rates will average to the rate the central bank pays on targeted reserves (see Baughman and Carapella 2019b). 

In addition to individual errors, aggregate targets may diverge from aggregate reserves because of unexpected changes in the aggregate quantity of reserves resulting from so-called autonomous factors, factors affecting outstanding reserves beyond the control of the Fed or commercial banks, such as payments by the US Treasury. The Federal Reserve's Markets Desk has the ability to undo some of this through open market operations, which were intensive before the move to a floor system. Pre-2008, when banks had binding fixed reserve requirements, there was no opportunity for the banks themselves to respond to anticipated changes in reserves. So, even if the banking system perfectly anticipated a move in reserves, such as those occurring every spring when corporations pay annual taxes, there was nothing banks could do to adjust their reserve position relative to requirements, and the Markets Desk had to intervene. Under a VRT system, banks can raise or lower their targets according to expected aggregate fluctuations. The Markets Desk would only need to respond to changes or errors which were both unexpected and aggregate in nature.

Finally, the analysis in Baughman and Carapella (2019a) explores the role of the central bank's reserve supply strategy for the implementation and effectiveness of a VRT. The operation of a VRT described in the previous paragraphs implicitly depends on the central bank publicly committing to an expected path for its balance sheet--at least in the short run--as the Federal Reserve has done for years. If a central bank does not commit to a balance sheet policy, but instead were to adjust its balance sheet and the supply of reserves passively to match targets chosen by banks, then the path of reserves may become unstable; banks' targets feed back through central bank's reserve supply to affect banks' targets. To obtain the benefits and flexibility of a VRT, it is crucial that the central bank be both committed to and transparent about the expected supply of reserves, the path of its balance sheet, and its operations in general.

Controlling Volatility

Fluctuations in aggregate reserves can cause rates to move under a VRT. If the quantity of reserves drifts above or below aggregate targets, the federal funds rate will tend to fall or rise, respectively. These movements would be largely bounded by the low rate on excess reserves and the fee charged for shortages, but the structure of a VRT provides the basis for other methods of controlling rate volatility not available in a floor.

An old and well worn tool is termed reserve averaging.³ With reserve averaging, instead of having to meet targets on a day-by-day basis, banks would instead be allowed to meet their targets on average over a period, usually termed a maintenance period, of, for example, two weeks. With averaging, reserves deposited today are a perfect substitute for reserves any other day in the maintenance period.⁴ Because of this substitutability, a bank wouldn't borrow today if it thinks rates would be lower tomorrow, nor would a bank lend if it thought rates were going to be higher tomorrow. By inducing intertemporal arbitrage, reserve averaging reduces the deviation of rates from day to day. This logic only applies, however, when requirements are expected to bind. So, while reserve averaging was effective at limiting volatility in the federal funds rate before the Fed moved to a floor system in 2008, the subsequent growth in the level of reserves made reserve requirements irrelevant for almost all banks; reserve averaging no longer helps to limit volatility. With a VRT, reserve averaging can be effective no matter the aggregate level of reserves because targets track expected reserve balances, so are expected to bind by design.

Another tool to limit the variability of rates are tolerance bands.⁵ Instead of enforcing targets strictly, tolerance bands give some room for error around targets. If a bank falls short of the target, but within the band, it would be charged no fee. If a bank is over its target, the rate on targeted reserves would be applied to the portion of the overage within the band with further excesses earning the low rate on excess reserves. Tolerance bands help control volatility by creating a range of elastic demand for reserves at the target rate. Different levels of reserves within the band all earn the target rate, so small perturbations in aggregate or individual reserves do not affect the market.

Tolerance bands as traditionally implemented, however, interact badly with voluntary targets, creating asymmetric incentives. When tolerances are expressed as a proportion of targets, a higher target effectively expands one's tolerance band. This gives an incentive to shade targets higher than expected reserves, resulting in average rates above the rate on targeted reserves. Indeed, when operating a system of voluntary reserve targets, the Bank of England experienced exactly this upward bias in rates.⁶ This problem, however, is relatively minor and is easily remedied by making the width of tolerance bands not dependent on targets, per se, but instead based on something unrelated to current targets, such as a proportion of lagged reserve holdings.

The Bank of England implemented a VRT framework in 2006 exactly for the purposes of controlling rate variability. The Bank of England lacks the authority to enforce reserve requirements and was having increasing difficulty controlling volatility in the sterling money market (the British equivalent to the federal funds market). Hence, in order to employ reserve averaging and tolerance bands, the Bank turned to VRT. As detailed in Osborne (2016), the reforms succeeded in limiting rate variability. But, with the onset of the financial crisis, the Bank abandoned their VRT system for a floor believing that the Bank's large and increasing operations would make it difficult for participants to accurately forecast reserves and set targets. It's possible that a program of transparency regarding the Bank's operations--so, the planned path of reserves--would have allowed banks to set appropriate targets. If banks have enough information to set targets, a VRT system could be compatible with quantitative easing. Even before quantitative easing, instead of committing to a path for reserves, the Bank followed a policy of supplying to aggregate targeted reserves. Consistent with the instability results of such a policy described in Baughman and Carapella (2019a), aggregate reserves fell over the period by more than a quarter, from over 24 to under 18 billion pounds. A policy of committing to a balance sheet path may have prevented this decline.

Other Potential Benefits of VRT

Besides the benefits mentioned above--the ability to hit target rates without active intervention, and the potential to control rate variability--a VRT might come with a number of other benefits. It may encourage banks' active management of their balances, reduce the effect of something termed discount window stigma, and allow a smaller overall balance sheet for the central bank.

Under a VRT system, banks target their expected balances, and any unexpected withdrawal or deposit puts a bank in a position to borrow or lend. Under a floor, it is only when a bank's balances reach near zero that they will need to trade. Another way of phrasing this, a VRT encourages banks to actively manage their reserves. While this management could pose modest costs to banks, active management of liquidity is at the core of a bank's business, and better management in this activity may lead to better bank management overall.

Indeed, encouraging active management formed the stated purpose of the contractual clearing balances (CCB) program. Highly reminiscent of a VRT, banks who participated in the CCB would negotiate with their Federal Reserve Bank a target balance to maintain in excess of their reserve requirements. In turn, the Federal Reserve remunerated these balances with credits for Federal Reserve priced services, such as wire transfer fees. The Fed remunerated banks with fee credits because it lacked the authority to pay interest on reserves. The Fed abandoned the program in 2011 after gaining authority to pay interest on reserves and moving to a floor system.⁷

Besides encouraging active balance management, a VRT can operate with either large or small aggregate balances. If the Federal Reserve maintains a larger balance sheet than prior to the crisis, and banks actively manage their reserves, there may be fewer banks who reach near-zero levels. This reduces the need for banks to borrow directly from the Federal Reserve, reducing the Fed's credit exposure. Further, for many years, banks have expressed an extreme reluctance to borrow through the discount window due to a perception in the market that only highly distressed banks need borrow in this way--the stigma of the discount window. Since the fee on shortages is automatic and completely administratively distinct from the discount window, it can provide a ceiling on rates without invoking stigma, a further mechanism to reduce volatility. Indeed, shortages are part of the normal functioning of a VRT, and one would expect to regularly observe some banks in shortage.

Finally, as aggregate targets track aggregate reserves, VRT encourages active markets which could possibly reduce the steady state size of the Federal Reserve's balance sheet relative to the current floor system. The ability to borrow in the interbank market provides a form of ex-post liquidity insurance to banks. Without this insurance, banks must hold greater precautionary balances. This might explain why the federal funds rate has lifted above IOER despite the still extremely high level of reserves in the system--banks demand more reserves in aggregate than they otherwise would because the federal funds market, which reallocates reserves late in the day, has been disrupted by a lack of participation. A VRT would encourage the reemergence of this market and the concomitant liquidity insurance, allowing the Fed to continue reducing the quantity of reserves and so its balance sheet.

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