Description:
When the Federal Reserve first paid interest on excess reserves (IOER) on October 2008, financial institutions faced a choice to invest in reserves to earn a “better than” risk-free rate, or lend to earn a higher, but riskier rate. Evidence suggests the “reserves-lending puzzle” is not driven by reserves arbitrage, a flight to safety, or reverse causality, but by a market-based “reserve premium” (IOER-3MT), which may have reduced domestic bank-level lending by -6.7% (-$559.3B). Empirical findings indicate that IOER transformed the “risk channel” as lower reserve premiums - as opposed to lower policy rates - incentivize bank risk-taking. Additionally, recent Senior Financial Officer Surveys corroborate the conclusions presented in this paper