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I've found this link of San Francisco Fed. In it, it's stated that the Federal bank began «paying interest on reserves held against certain types of deposit liabilities.(...) This was important for monetary policy because the Federal Reserve’s various liquidity facilities initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances.»

I need help on clarifying the sentence in bold. Which facilities were those? What's the problem on an upward pressure on excess reserves, and downward pressure on the Federal funds rate?

Any help would be appreciated.

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The Federal Reserve set up a number of emergency liquidity facilities during the financial crisis, including:

  • The Primary Dealer Credit Facility, which provided liquidity to nonbank primary dealers (nonbanks do not have access to the discount window, which is the traditional mechanism of liquidity provision to banks)
  • The Term Auction Facility, which provided term funds to banks through an auction mechanism
  • The Term Securities Lending Facility, which loaned securities to alleviate shortages of Treasury collateral
  • Currency swap lines with foreign central banks, which addressed shortages in overseas dollar funding markets
  • and others.

Many of these programs resulted in banks having large piles of cash (not literally, of course— these were electronic "piles" of cash). When banks have large piles of cash (i.e., excess reserves), they're willing to loan that cash at really low rates, because they have nothing else to do with it— hence the "downward pressure on the Federal funds rate." This is just a result of supply and demand in the market for cash— when the supply of cash increases, the price of cash (i.e., the interest rate on a Federal Funds loan) decreases. The problem, however, is that you don't want rates to do negative, because negative rates are believed to have seriously negative implications for the standard model of banking. As a result, the Fed began paying interest on excess reserves, to set a floor under Fed Funds rates.

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  • $\begingroup$ Could you please give a link to this standard model of banking? $\endgroup$ – An old man in the sea. Dec 10 '15 at 17:37
  • $\begingroup$ I'm simply referring to deposit-funding of loans as described in any textbook, where deposits are paid some amount and used to make loans at a positive spread; it's not a "model" in the economic sense (though many economic models of banking incorporate these features), but in the general sense. Negative rates become particularly problematic when they spill over into retail deposits, encouraging depositors to withdraw their money and hold it as physical cash. $\endgroup$ – dismalscience Dec 10 '15 at 18:17
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Downward pressure on the Federal funds rate means bringing interest rates down even further (to ~0%).

Upward pressure on excess reserves likely means increased incentive for banks to build up excess reserves. The part about reserves is bit ambiguous. After reading the article a couple of times, this is what I make out of the paragraph (my comments are in bold):

This was important for monetary policy because the Federal Reserve’s various liquidity facilities initiated during the financial crisis caused upward pressure on excess reserves (provided banks with cash to increase reserves) and placed downward pressure on the Federal funds rate (lowered the interest rate to the target level ~0). To give Fed a tool to counteract these pressures in the future when they decide to exit QE and tighten the monetary policy, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances. Paying interest on reserves gave the banks incentive to increase the reserves at the time. In the future, lowering interest rate paid on reserves would create downward pressure on excess reserves.

I found a footnote next to "Federal Reserve’s various liquidity facilities" part of the sentence leading to a page describing these facilities: Credit and Liquidity Programs and the Balance Sheet. It looks like a detailed technical description of QE programs Fed implemented after the 2008 crisis.

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  • $\begingroup$ Arthur, thanks for the answer, but I still have some doubts. What would be the problem if the funds rate was close to zero? Are you sure that «Upward pressure on excess reserves means increasing pressure on banks to reduce excess reserves.» From the graphic, with the crisis, the excess reserves increased, and it doesn't seem logical to say that the banks reduced their excess reserves during, and immediately after the crisis... $\endgroup$ – An old man in the sea. Dec 10 '15 at 10:05
  • $\begingroup$ After reading it multiple times, I am having doubts. I expanded my answer with some comments to the paragraph. I am still not 100% sure so please let me know if it seems inaccurate to you. $\endgroup$ – Arthur Tarasov Dec 10 '15 at 12:58
  • $\begingroup$ This is a good attempt; unfortunately it's quite wrong. The 2008 liquidity programs referenced in the link had nothing to do with QE, as QE did not exist yet. The first round of quantitative easing was announced on November 25, 2008; IOER was announced on October 6, 2008. You're not wrong in your belief that IOER is helpful today in dealing with extra reserves created by QE, but that's not how it was used at the time (though the possible future need to engage in QE, and what programs that might necessitate, was almost certainly contemplated). $\endgroup$ – dismalscience Dec 10 '15 at 17:04
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It's important to put this into historical context. During the crises, we were in essence suffering a bank run. Liquidity crisis is code for bank run.

But modern bank runs look different from old time bank runs. Modern banks are divided into (roughly) two camps. Local depositor banks and larger investment banks. There is a complex inter-bank lending market that connects the different types and assures banks have enough reserves to avoid insolvency. In a modern run, banks actually fear losing the support of other banks more so than depositors.

This is important as all banks are inherently insolvent and need to be propped up by other banks in turn by a central monetary source (like the Fed). This is because they mismatch short term liabilities with long term assets. If I take out a one year loan to buy a ten year bond, I am very dependent on that one year being perpetually rolled over. Same with bankers. The Fed subsidizes the short term debt market to them, so they can make more money mismatching short term debt with long term assets.

During the crises, the money market shut down. To academia...this wasn't supposed to happen because of the open market. But it did. The reason it did was because banks stopped trusting each other and we had a very modern bank crisis on our hands. Banks tried to reverse maturity mismatching by holder more short term assets (like reserves), but this is impossible in the aggregate and actually causes more of a crisis.

The idea behind the Fed paying banks for reserves, is that it provides them with a source of short term assets to help deal with pressing short term liabilities. QE on the other hand helped deal with banks change long term assets for shot term from the Fed.

Normally, the Fed bails out (and does so constantly each year) bank crises through the open market. If a bank is seeing their short term debt called in, they borrow from the money market which in turn borrows from the Fed. So indirectly banks are guaranteed their source of short term debt to perpetuate their maturity mismatching.

Whether the government should be using public resources to prop up such behaviour is a very good question. Some central banks actually have considered measures to CHARGE interest on excess reserves, to encourage lending on the Fed Funds market and to help other banks overcome their liquidity concerns.

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  • $\begingroup$ Thanks for your answer. I really liked it. It was a small lesson. :) Could you elaborate on the following sentence, please? "Banks tried to reverse maturity mismatching by holder more short term assets (like reserves), but this is impossible in the aggregate and actually causes more of a crisis." Why is it impossible in the aggregate? Because someone would have to buy those long-term assets keep them all? $\endgroup$ – An old man in the sea. Dec 12 '15 at 9:20
  • $\begingroup$ A bank promises money they do no have. Let's take the shortest term debt a bank has...a checking account (which matures and rollsover on an infinitely small time scale). Bank deposit liabilities (as defined by M2) in the US is roughly 9.5 trillion dollars. But base money (what the deposits promise) is only 4 trillion dollars. Hmmm... If everybody were to demand their M2 as MB, it could not happen. But is more likely to happen if the public suspects a run. Nobody wants to be without a chair when the music stops! Same maturity mismatch principal happens to other accounts as well. $\endgroup$ – user2662680 Dec 12 '15 at 15:17
  • $\begingroup$ It should be noted that academia does to a limited extent keep an eye on maturity mismatching. The LMI (or liquidity mismatch index) is used by some but is needless complicated. If you are interested in a more formal, academic view of this, here is an example: cba.uri.edu/research/brownbag/fall2013/documents/… $\endgroup$ – user2662680 Dec 12 '15 at 15:32

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