Why Obscure Fed Policy Might Mean Higher Bank Fees

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Since the financial crisis, customers have gotten used to their banks cutting perks like debit card rewards and raising fees for account maintenance and other services. In the first half of 2013, bank customers paid an average monthly fee of  $12.43, according to the most recent MoneyRates.com survey. This might sound steep, but things could get even worse next year. 

A little-noticed item on the minutes of the Federal Reserve‘s recent Open Market Committee meeting noted, “Most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage.”

Although that sounds pretty benign, banks say the trouble is that the Fed is only paying them 0.25% on those funds to begin with. If that percentage drops, banks say their expenses would go up, and banking experts say they would likely pass these onto their customers in the form of fees.

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First, a history lesson: The Fed never paid banks that much to park their excess reserves with it. Before the financial crisis, the Fed had two rates — one for required reserves, one for excess reserves. The former was higher, with the idea being that banks could be compensated for having to lock up that money to comply with regulations and that the rate would influence monetary policy by acting as a kind of floor for bank lending rates: A bank wouldn’t take a lower interest rate from another institution than it could get at the Fed.

In 2008, the Fed changed this, with the result that all that reserve money earned the same amount of interest. The numbers involved are all tiny — fractions of percentage points — but banks collectively have $2.4 trillion in reserves at the Fed, the vast majority of which is excess reserves. They’ve been able to accrue this cache thanks to the Fed’s aggressive intervention in the wake of the financial crisis. The intention was that these efforts would give the banks some breathing room and encourage them to start lending again, but it didn’t really work out like that.

Banks found they could make more money warehousing these funds with the Fed than using them for other investments. “Currently, banks receive a higher interest rate from holding excess reserves than from holding three-month Treasury bills,” an economist at the Federal Reserve bank in Atlanta observed back in 2009. As long as policymakers maintained that status quo, he said, “There is no obvious reason why excess reserves will decline.”

In other words, the status quo has been working out for banks, and they don’t want to give that up, so they’re threatening to raise fees if the Fed follows through with this idea. “Executives at two of the top five US banks said a cut in the 0.25 per cent rate of interest on the $2.4tn in reserves they hold at the Fed would lead them to pass on the cost to depositors,” the Financial Times says. “Right now you can at least break even from a revenue perspective,” one executive told the newspaper.

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Whether or not the Fed will go through with this rate cut is an open question; people make entire careers out of guessing what the Fed is going to do next. Although there are some good reasons why the Fed might not want to go tinkering around with the rate, “There certainly seems to be some momentum behind the concept,” says Nancy Atkinson, a senior analyst at the Aite Group.

That could make it even more expensive for fee-weary customers. “Banks are operating in an environment of severe pressure on their revenue,” says Peter Aykens, managing director at CEB. “If the Fed lowers the rate it pays to banks, they will seek to offset that revenue loss somewhere.”

Yep, that means more fees, or higher fees, or some combination of the two. “In a low rate environment, retail banks have little room to adjust interest rates,” Aykens says. Banks just aren’t making the kind of money they used to be able to make by holding depositors’  money. “Fees would be the place banks would most likely go to offset the revenue impact.”

“It will not be easy for retail banks to recoup lost revenue from the Fed by simply raising fees on deposit accounts,” Aykens said. He predicts that the path of least resistance for banks will be to increase account maintenance and minimum balance fees. Banks could also generate more fee revenue by withdrawing some of the waivers they currently extend that let customers avoid those monthly fees.

At a certain point, of course, consumers will push back: Banks found that out two years ago when they tried to charge monthly fees for people to use their debit cards, which turned into a PR nightmare. This painful memory might make banks think twice about trying to jack up fees while blaming the government.