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Since 14th Dec 2017, the Federal Reserve Bank has paid 1.50% interest on excess reserves.

So why do depositors' interest rates still remain so low? According to BankRate, across the US, the national average savings account interest rate is 0.09% and only a handful of banks offer 1.50% or more.

The Econ 101 story would go something like this:

If Bank A offers 1% and Bank B offers 1.3%, then consumers will move all their savings to Bank B. Bank A will then compete by raising its rate to 1.31%, which is still profitable since it can deposit its money at the Fed for 1.50%. Bank B will then raise to 1.32%, etc. Competition will ensure that the interest rate is driven up towards 1.50%.

I imagine there are some transaction and administrative costs, but I don't see how these could explain the huge gap between the national average savings interest rate (0.09%) and the interest rate paid by the Fed to banks (1.50%). I do believe also that there is no limit to the reserves that banks can place with the Fed (though please correct me if I'm mistaken on this point).

What am I missing here? Or: Why does this market deviate markedly from the perfectly competitive ideal?

Some possible general explanations off the top of my head (but I suspect there may be other more specific institutional factors that I'm not aware of):

  1. Consumer ignorance. (Similar to this recent working paper which documents that people fail to pay off those credit card debts that charge the highest interest, and instead adopt some sub-optimal "balance-matching" heuristic.)
  2. Consumers face transaction/psychic costs moving their money about, setting up new accounts.
  3. Banks offer other services, so consumers may still prefer to save with a bank despite its lower interest rate.
  4. Menu costs - it's somehow costly or maybe bad publicity to frequently change the bank's savings rate.
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  • $\begingroup$ "Banks offer other services, so consumers may still prefer to save with a bank despite its lower interest rate." is correct - the evidence is that consumers have been willing to endure negative interest rates on deposit accounts in parts of the world. Foregoing %1.5 annual interest for the convenience of ATMs, credit cards, bank transfers and the security of a "bank vault" seems to be a good deal to plenty of customers - otherwise, they would've withdrawn their money and held cash instead. $\endgroup$ – Starfall Feb 9 '18 at 4:15
  • $\begingroup$ On your point about reserves: the amount of reserves in the system are determined by the creation of base money by the Fed’s open market operations. All of those reserves have to remain on deposit at the Fed (unless they are withdrawn for notes and coins). There are no other limits. $\endgroup$ – Brian Romanchuk Feb 9 '18 at 12:57
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There are several issues here:

  • There are banks offering close to $1.5\%$, some well-known such as Goldman Sachs and American Express
  • Most banks currently have excess reserves deposited in the Federal Reserve System which they could use for lending if they wanted to, so they are not missing profitable commercial lending opportunities due to lack of deposits
  • Many customers are leaving their money in very low interest accounts, possibly through inertia or the attraction of other banking services, and so banks have less incentive to push up interest rates. If customers want more, they can go for longer-term certificates of deposit yielding over $2\%$
  • In eras of "normal interest rates", banks took a margin. For example the old anecdotal 3-6-3 rule for bankers (pay $3\%$ percent interest on deposits, lend money out at $6\%$, and tee off at the golf course at $3$ p.m.) might have been associated with a base prime rate of around $4-5\%$ percent and a default rate of around $1-2\%$. So with a base rate of $1.5\%$, short-term savings rates should not be expected to be close to this. Earlier in the cycle when Fed interest on excess reserves rates were $0.25\%$, this margin was not compatible with positive savings rates; only now are banks able to restore their margins
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  • $\begingroup$ Your last point on margins is the key here. Banks have expenses, and need to make a profit. Deposit funding has to be cheaper than borrowing in the wholesale market in order for banks to offer retail deposit services. If deposits had the same rate as commercial paper, a bank would just shut down its branches and fund itself in the money market. $\endgroup$ – Brian Romanchuk Feb 9 '18 at 12:48
  • $\begingroup$ @BrianRomanchuk Northern Rock tried money market funding, and found it profitable until the money markets' liquidity freeze in 2007 and it could not roll over its borrowing $\endgroup$ – Henry Feb 9 '18 at 14:49
  • $\begingroup$ Yes, it works until it doesn’t. I am not saying that it is a good idea, just that it is a competitor for banks. I think you largely answered the question, but I just stuck some added points rather than comment any more here (like I am now, oops). $\endgroup$ – Brian Romanchuk Feb 9 '18 at 16:11
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Interest on reserves is not that significant a factor in a low interest rate regime. If the bank did not hold reserves, it would hold Treasury bills as a liquidity buffer, and they pay about the same amount as the policy rate. I believe the reserve ratio is 10%, so the difference between paying and not paying interest on reserves is worth 15 basis points (.15%) if the policy rate is 1.5%. So the interest spread might be a bit tighter than was the case when interest was not paid on reserves.

The net interest margin and fees are how banks pay expenses, and earn a profit. In order for a bank to offer banking services, it needs an interest advantage on deposits versus short-term wholesale borrowing. Otherwise, it can be replaced by a non-bank financial intermediary that grants loans and funds itself entirely in the money and bond markets. Since banks of the same size have a similar cost structure, their target interest margin is similar.

I believe that the idea behind a perfect equilbrium is that there is a potentially infinite number of new entrants to compete away profits. That is obviously impossible in the banking industry; you need capital, and there is a large time commitment to getting a banking license. Furthermore, you will have large fixed costs (branch, personnel, capital) that have to be covered in order to be viable.

It is not hugely surprising that customers are not too sensitive to posted rates on deposits. The availability of services and other fees may be far more significant than what they earn. Where there is competition for deposits is in the certificate of deposit (CD) market. (I believe, I am Canadian, but I believe that our GIC’s operate similarly to CD’s.)

A major factor for customer stickiness (on top of what you mention in the question) is a significant number of households and firms have debts with banks. It would be awkward to have your deposits with one bank, and your mortgage with another. Since the bank sees all your cash flows, it is presumably easier to negotiate new borrowing with your existing bank.

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