Interest on Reserves and Daylight Credit

B anks hold reserves in the form of account balances at the central bank and vault cash. The average aggregate reserves of depository institutions in the United States during 2005 was $46 billion. Banks use these reserves to settle payments to other banks (and other participants in financial markets) during the day. In 2005, the average daily value of Fedwire fund transfers—the primary means by which banks transfer funds to one another— was approximately $2 trillion; that is, nearly 50 times the quantity of reserves. When reserves do not pay interest overnight, banks face an opportunity cost from holding reserves overnight. However, if overnight overdrafts resulting from ending the day with insufficient reserves imply a penalty (in terms of higher interest rates or other types of penalties), then holding reserves may also be associated with the benefit of avoiding potential overdrafts. On average, during 2005 banks held a total of $1.7 billion in excess reserves; that is, reserves in excess of required reserves (see Table 1). In September 2006, Congress passed legislation that authorized the Federal Reserve to pay interest on banks’ reserve balances, beginning in 2011. The legislation also granted the Board of Governors additional flexibility in setting reserve requirements for depository institutions after October 1, 2011. According to this new legislation, the Federal Reserve can pay interest on all types of balances, including required reserves, supplemental reserves, and contractual clearing balances, held by or for depository institutions at a reserve bank. Such interest, if authorized by the Board, may be paid at least once each