Abolishing the Federal Reserve's interest payment mechanism to reduce expenses? JP Morgan warns: this is not a viable solution!

J.P. Morgan strategists warn that the proposal to cancel the interest paid by the Federal Reserve to depository institutions may trigger multiple shocks in the banking industry, financing markets, and U.S. monetary policy. Texas Senator Ted Cruz proposed last week in an interview that Congress should consider cancelling Interest on Excess Reserves (IORB) payments to reduce government spending. He revealed that the Senate has initiated "in-depth discussions" on this matter, but remains cautious about the practical possibility of policy adjustments. Currently, the Federal Reserve pays interest on around $3.2-3.3 trillion in bank reserves at a rate of 4.4%. According to calculations by J.P. Morgan strategist Teresa Ho, if we assume an average of $3 trillion in reserves and a rate of 3.5%, cancelling IORB could save the government approximately $1 trillion in expenditures over ten years. IORB was established during the global financial crisis almost twenty years ago to support financial system stability, and has now become a core tool for the Federal Reserve to control short-term interest rates. J.P. Morgan analysis indicates that abolishing this mechanism could change banks' liquidity management practices, potentially causing funds to flow back into money markets, squeezing the existing players in the treasury, repurchase agreements, and federal funds markets. Ho and her team wrote in a report to clients on June 6th, "This move will significantly impact bank profitability and liquidity management strategies, lower short-term interest rates, increase the frequency of use of the Federal Reserve's standing facilities, and, more importantly, may cause the Fed to lose its control over money market interest rates." Back in 2006, Congress authorized the Federal Reserve to pay interest on reserves through the Financial Services Regulatory Relief Act, originally planned for implementation in 2011 but expedited due to the 2008 financial crisis as a critical means of maintaining financial stability during turbulent times. Subsequently, policymakers introduced overnight reverse repurchase agreements (ON RRP) paying interest to cash counterparties held at the central bank to strengthen the Fed's ability to regulate short-term interest rates. The strategists pointed out that if Congress were to abolish IORB, bank profitability might decrease, and the cost of holding reserves would significantly rise especially considering regulatory requirements such as the liquidity coverage ratio (LCR) and internal liquidity stress tests defining the minimum liquidity levels. This implies that financial institutions might be forced to take on higher risks, while their liquidity management strategies would need fundamental adjustments. Regarding money market interest rates, more funds may flow into treasury, repurchase, and federal funds markets, driving down yields of related assets and making it difficult for the Fed to prevent short-term money market rates from falling below the target range lower limit. The strategists further analyzed that supply-demand imbalances could lead to more trading partners relying on overnight reverse repo tools, forcing the central bank to pay more interest to market participants; if banks experience a liquidity squeeze due to lower reserves, they might resort to using standing repo facilities (SRF) and the discount window. Behind Cruz's proposal, there lies a deep discussion about whether the Fed should return to its pre-crisis policy framework setting a minimum lending rate to financial institutions and implementing monetary policy through daily operations in the reserves market. Therefore, abolishing IORB could prompt the Fed to return to this "corridor" system, and potentially reduce the size of its balance sheet. However, J.P. Morgan strategists believe this scenario is less likely, as it would result in more treasury securities in the hands of "non-Fed holders," thereby increasing overall Treasury market term premiums. "In essence, abolishing IORB may jeopardize the Fed's control over money market interest rates, making its monetary policy operation more complex through the federal funds rate and other money market rates to guide the overall financial environment," wrote Ho and her team, "IORB and ON RRP are core tools for managing liquidity in times of surplus or adequacy in reserve balances."