An advance notice of proposed rulemaking (ANPR) on whether to revise Regulation D to reduce the rate of interest paid on excess reserve balances (IOER) held at the Federal Reserve Banks by “eligible institutions” that hold a very large proportion of their assets in the banks is out for a 60-day comment period, the Federal Reserve Board announced Wednesday.
The Fed is focusing in particular on reserves maintained by “pass-through investment entities” (PTIEs) and their potential impacts on the financial system.
The Fed notice said some financial firms have sought to establish special state charters for depository institutions with narrowly focused business models that involve taking deposits from institutional investors and investing all or substantially all of the proceeds in balances at Reserve Banks. Such institutions – PTIEs – would not be subject to federal prudential regulation or the same set of capital and other prudential requirements as other federally regulated banks, it said. These entities, the Fed said, could theoretically attract a very large quantity of deposits from institutional investors by paying a rate that is nearly identical to the IOER rate (currently set at 2.4%), except for a small spread retained by the PTIE.
“Avoiding regulatory costs borne by other eligible institutions and unconstrained by meaningful capital requirements, PTIEs could effectively extend the IOER rate to their depositors that are not themselves ‘eligible institutions,’ and would be able to do so on a potentially very large scale,” the Fed said in its notice. “A proliferation of similar PTIEs could magnify these effects across the financial system.”
The Fed is particularly concerned about the impact of such entities’ activities on how the Fed implements monetary policy; and the possibility that they could disrupt financial intermediation “in ways that are hard to anticipate” and negatively affect financial stability.
A variety of potential impacts are noted: on the Fed’s balance sheet activity, potential volatility in the federal funds rate, and spillover effects on markets such as federal funds futures, overnight index swaps, floating-rate bank loans, and Treasury securities, to name some.
“More generally, a large-scale migration of institutional cash investors to deposits at PTIEs and away from other depository institutions, money market mutual funds, or repo markets could result in smaller trading volumes across a range of unsecured and secured overnight money markets,” the Fed stated.
The Fed notice acknowledges the views of some that PTIEs could actually strengthen the Fed’s hand in managing monetary policy, but it calls such potential benefits “modest.”
Comments are sought on all aspects of this issue. In particular, the Fed is seeking comments on whether it should amend Regulation D to provide for a lower IOER rate for PTIEs, and how to set that rate; how a PTIE should be defined (for example, based on reserves held, capital, or lack of supervision by federal bank or credit union regulators); and public policy concerns, pro and con.