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

According to Zhitong Finance APP, JPMorgan Chase strategists warn that the proposal to eliminate interest payments on reserves to deposit institutions could trigger multiple shocks to the banking industry, financing markets, and U.S. monetary policy.

Texas Senator Ted Cruz suggested in an interview last week that Congress should consider eliminating Interest on Reserve Balances (IORB) payments to reduce government spending. He revealed that the Senate has begun "in-depth discussions" on this matter but remains cautious about the actual possibility of policy adjustments.

Currently, the Federal Reserve pays interest on approximately $3.2-$3.3 trillion in bank reserves at a rate of 4.4%. JPMorgan Chase strategists, led by Teresa Ho, estimate that if we consider an average of $3 trillion in reserves and a 3.5% interest rate, eliminating IORB could save the government about $1 trillion in spending over ten years.

IORB was established during the global financial crisis nearly twenty years ago to support the stability of the financial system and has since become a core tool for the Federal Reserve to control short-term interest rates. JPMorgan Chase's analysis points out that abolishing this mechanism would change banks' liquidity management models, potentially leading to a flow of funds back into the money market, squeezing the space for existing participants in the Treasury, repurchase agreement, and federal funds markets.

In a report to clients on June 6, Ho and her team wrote: "This move will significantly impact banks' profitability and liquidity management strategies, lower short-term interest rates, increase the frequency of the Federal Reserve's permanent tools, and, more critically, may cause the Federal Reserve to lose control over money market rates."

Congress authorized the Federal Reserve to pay interest on reserves as early as 2006 through the Financial Services Regulatory Relief Act, originally planned for implementation in 2011, but was expedited due to the 2008 financial crisis, becoming a key tool for maintaining financial stability during turbulent times. Subsequently, policymakers introduced the Overnight Reverse Repurchase Agreement (ON RRP) tool—paying interest to cash counterparties held at the central bank—to strengthen the Federal Reserve's ability to control short-term interest rates.

Strategists point out that if Congress does abolish IORB, banks' profitability may decline, and the cost of holding reserves will significantly increase—especially as regulatory requirements such as the Liquidity Coverage Ratio (LCR) and internal liquidity stress tests stipulate minimum liquidity levels. This means financial institutions may be forced to take on higher risks, while their liquidity management strategies will face fundamental adjustments.

Money Market Rates

In terms of money market rates, more funds will flow into Treasury, repurchase, and federal funds markets, pushing related asset yields down, making it difficult for the Federal Reserve's reverse repurchase tool to prevent short-term money market rates from falling below the lower limit of the target range.

Strategists further analyze that supply-demand imbalances may lead more counterparties to rely on overnight reverse repurchase tools, forcing the central bank to pay more interest to market participants; if banks experience liquidity shortages due to reduced reserves, they may even turn to the Standing Repo Facility (SRF) and discount window Cruz's proposal implies a deep discussion about whether the Federal Reserve should return to the pre-crisis policy framework—specifically, by setting a minimum loan rate for financial institutions and implementing monetary policy through daily operations in the bank reserve market. Therefore, abolishing IORB could prompt the Federal Reserve to return to this "interest rate corridor" system and potentially reduce the size of its balance sheet.

However, JPMorgan Chase strategists believe that this scenario is less likely, as it would lead to more government bonds flowing into the hands of "non-Federal Reserve holders," thereby pushing up the overall term premium in the government bond market.

"Essentially, abolishing IORB could jeopardize the Federal Reserve's control over money market rates, complicating its monetary policy operations that guide the overall financial environment through the federal funds rate and other money market rates," Ho and his team wrote. "In a situation of ample or excessive system reserves, IORB and ON RRP are core tools for managing liquidity."