Interest on Reserves

Depository institutions hold reserves on deposit with Federal Reserve Banks. These reserves help these institutions manage their liquidity, meet payment needs, and satisfy regulatory requirements. Historically, the Fed did not pay interest on those reserves. Proposals to allow the Fed to pay interest on reserves were first debated in the 1970s in the context of a decline in membership in the Federal Reserve System. Debate continued in the 1990s and early 2000s in the context of reducing the burden of bank regulation and enhancing the Fed's monetary policy toolkit. Since Congress authorized the Fed to pay interest on reserves beginning in 2008, such payments have become a key tool of monetary policy to control short-term interest rates.

1970s decline in membership

Historically, for commercial banks considering membership in the Federal Reserve System, reserve requirements were a cost of membership, since the Federal Reserve did not pay interest on reserves. Banks weighed this cost against the benefits of membership, which included access to the Fed's discount window and payment services, the latter of which were provided at no cost to members until 1980. Overall, the question of whether the Fed could or should pay interest on reserves was largely dormant during the first half-century of the Fed's history as long as banks found membership attractive enough.

In the 1970s, a number of state-chartered banks gave up membership in the Federal Reserve System. These banks largely attributed their exit to the increased costs of reserve requirements amidst the rising interest rate environment of that decade. Contemporaries widely began describing the lack of interest payments as equivalent to a "tax" on member banks (Staff of the Board of Governors 1977). In addition, during the 1970s the Federal Reserve made two payment services available to non-member banks: ACH (automated clearing house) payments and regional check processing facilities. While that open access was designed to promote economies of scale, it also reduced the comparative benefits of membership. As a result, membership fell. Federal Reserve member banks accounted for 49 percent of commercial banks and 85 percent of commercial bank deposits in 1950, but by 1980 these figures had declined to 38 percent of banks and 71 percent of deposits (Federal Reserve Bulletin, July 1950 p. 851 and October 1980 p. A112).

The decline in membership sparked several concerns at the Federal Reserve. Fed officials worried that the implementation of monetary policy could become more difficult. At the time, the Fed conducted monetary policy by changing the amount of reserves supplied to banks, with the goal of affecting the broader money supply. Fed officials were concerned about losing their ability to accurately predict the effects of their operations as the number of banks holding reserves with the Fed shrank. In addition, Fed officials pointed out that they had pivoted away from using changes in reserve requirements as a tool of monetary policy because of the declining membership. Fed officials also worried that their ability to stem a financial crisis would be limited if more banks gave up direct access to the Fed's discount window (Staff of the Board of Governors 1977).

Proposals to pay interest on reserves became part of calls for a more general rationalization of the bank regulatory structure in the 1970s amidst changes in the financial services landscape. Some discussions linked proposals to pay interest on reserves with the payment of interest on demand deposits, for example. Banks had been prohibited from paying interest on demand deposits since 1933 but increasingly were finding ways to implicitly compensate depositors. Payment of interest on reserves was seen as a way of defraying the costs to banks of proposals to lift the prohibition of interest payments on demand deposits (Staff of the Board of Governors 1977). Proposals to pay interest on reserves were also linked to proposals for the Fed to charge member banks for payment services. Charging for payment services was designed to level the playing field between the Fed and private sector providers of payment services, and the payment of interest on reserves was proposed as a way of offsetting the resulting costs to member banks.

The effects that paying interest on reserves would have on Fed membership, monetary policy, and financial services regulation were broadly debated up to the passage of the Monetary Control Act of 1980.

The Monetary Control Act of 1980

A key step in the runup to the Monetary Control Act was a proposal issued by the Board of Governors in 1978 (Board of Governors 1978). That proposal had the following components:

1. Universal reserve requirements to all banks, thrifts, and credit unions

2. Reduction and simplification of reserve requirements

3. Charging for Federal Reserve payment services

4. Payment of interest on reserve balances

5. Compensation to the Treasury for lost revenue

This package of proposals was designed to overhaul the incentives for membership in the Federal Reserve System. Universal reserve requirements and charging for Federal Reserve payment services were both designed to level the playing field between member banks and other depository institutions. The reduction and simplification of reserve requirements was designed to decrease the overall burden of those requirements in the process of extending them to new institutions. The proposal to pay interest on reserves was mainly designed to lower the costs of membership and offset the cost of charges for payment services.¹

The payment of interest on reserves likely would have resulted in the reduction of the Fed's remittances to the Treasury. In anticipation of that concern, the Fed proposed to cap interest payments at a certain percent of total Federal Reserve Bank earnings. The Fed also proposed that during the phase-in period the Fed would make transfers to the Treasury, out of the Fed's surplus, in an amount equal to the lost revenue. Fed officials also pointed out that, in the long run, remittances to Treasury would shrink if Fed membership continued to decline. Still, members of Congress, such as Senator William Proxmire, were concerned about the long-term budgetary costs of the Fed paying interest on reserves (Committee on Banking, Housing, and Urban Affairs 1979a, pp. 1-4).² G. William Miller, who had been chairman of the Fed at the time of the 1978 proposal but had since become Treasury Secretary, testified in early 1980 that the administration was also concerned about the cost and that he had become convinced that changes in reserve requirements alone could accomplish the Fed's goals (Committee on Banking, Housing, and Urban Affairs 1980, pp. 55-66). Fed officials pivoted as well toward a focus on universal reserve requirements. However, Paul Volcker, who became chairman of the Board of Governors in 1979, asked Congress to consider a compromise power in which the Fed could pay interest only on "supplemental" reserves that the Board could require for the purposes of monetary policy implementation (Committee on Banking, Housing, and Urban Affairs 1979b, pp. 8-15).

Ultimately, the 1980 act included the first three items from the Fed's 1978 proposal—universal reserve requirements, reduction and simplification of reserve requirements, and charges for payment services—but no general power to pay interest on reserves. Instead, Congress embraced Volcker's compromise proposal, allowing the Board to require and pay interest on supplemental reserves if "essential for the conduct of monetary policy." As the membership problem subsided, this provision would be unused but remained part of the Federal Reserve Act until 2006, when Congress revisited the subject of interest on reserves.

Regulatory relief

In the 1990s Congress began to consider legislation that would package together various forms of regulatory relief to financial institutions. In 1998, for example, a proposed piece of legislation would have authorized banks to pay interest on demand deposits and the Fed to pay interest on reserves, among other provisions. These two proposals had long been tied together. Testifying in 1998, Governor Meyer noted that the Fed had "commented favorably on such proposals on a number of previous occasions over the years" and continued to support such reforms (Meyer 1998). Fed officials would continue to support such proposals over the next several years.

By the 1990s and 2000s the debate was no longer about the costs of membership. Instead, the two main issues were regulatory efficiency and the Fed's toolkit for conducting monetary policy. In terms of efficiency, by the late 1990s banks had found ways to substantially avoid reserve requirements. For example, banks widely offered services in which they "sweeped" demand deposits into other instruments which were subject to lower reserve requirements and on which they could pay interest. Fed officials viewed these maneuvers as distorting the pricing of deposits and more generally as causing banks to engage in economically wasteful actions to work around existing regulations.

In terms of monetary policy, Fed officials viewed interest on reserves as a potentially useful tool for controlling overnight interest rates. For example, if overnight interest rates were to become volatile for some reason, the ability to pay interest on reserves would set a floor for overnight rates, limiting downside volatility. Governor Donald Kohn testified that this could be a useful tool, though "the Board sees no need to pay interest on excess reserves in the near future" (Kohn 2006).

Concerns about costs continued to weigh on the proposals for interest on reserves. In 1998, for example, Treasury official John D. Hawke Jr. reiterated this longstanding concern and recommended against such proposals, particularly during a time of relatively high profitability for commercial banks (Committee on Banking, Housing, and Urban Affairs, 1998, p. 75). Fed officials responded to the concerns about costs in a couple of ways. They pointed out that lost revenue for the Treasury would be relatively low, since banks had reduced their reserve balances. They also pointed out that demand for reserve balances would rise if interest were paid on reserves, causing the Fed to be able to hold more Treasury securities and remit greater levels of earnings (Meyer 1998).

In 2006, Congress passed the Financial Services Regulatory Relief Act, which authorized the Fed to pay interest on reserves. To delay the budgetary impact, the implementation date was set five years in the future, in 2011. The act authorized the Fed to pay interest on reserves at a rate "not to exceed the general level of short-term interest rates" and to adjust reserve requirements at its own discretion.

The 2008 financial crisis and subsequent changes to monetary policy implementation

The advent of the 2008 financial crisis altered the timeline for the implementation of the interest on reserves power. The Emergency Economic Stabilization Act, passed by Congress in October 2008, allowed the Fed to immediately begin paying interest on reserves. The concern at the time was that the Fed might have difficulty controlling short-term interest rates. The Fed had extended of discount window loans to financial institutions to address the financial crisis, but these actions increased the supply of reserves and would have put downward pressure on short-term rates by reducing bank demands for funds in money markets. The payment of interest on reserves was intended to put a floor on short-term market rates since banks would not have much incentive to lend below the rate they could earn on reserve balances at the Fed.

In practice, the floor created by interest on reserves was imperfect in late 2008, in part because some large nonbank lenders in the federal funds market were not eligible to receive interest on reserve balances at the Fed and therefore did have an incentive to lend at lower rates (Monetary Policy Report, July 2009). That experience helped motivate the creation of the overnight reverse repurchase (ON RRP) facility in 2013, which has further enhanced the Fed's rate control by paying interest to a broader set of financial institutions.

The Federal Reserve began raising its target range for the federal funds rate in 2022. Together, interest on reserve balances and the ON RRP offering rate have been highly effective at ensuring the federal funds rate has stayed within the FOMC's target range.

References

Board of Governors of the Federal Reserve System. (1978) Proposed legislation for program to promote competitive equality among member banks and other financial institutions and to encourage membership in Federal Reserve System. Press release, July 10. Available on FRASER.

Board of Governors of the Federal Reserve System. (1950) Federal Reserve Bulletin, July. Available on FRASER.

Board of Governors of the Federal Reserve System. (1980) Federal Reserve Bulletin, October. Available on FRASER.

Board of Governors of the Federal Reserve System. (2009) Monetary Policy Report to Congress, July 21. Available on FRASER.

Kohn, Donald. (2006) Statement before the Committee on Banking, Housing, and Urban Affairs. March 1. Available on FRASER.

Meyer, Laurence H. (1998) Testimony before the Committee on Banking, Housing, and Urban Affairs. March 3. Available on FRASER.

Committee on Banking, Housing, and Urban Affairs, United States Senate. (1980) Federal Reserve Requirements, S.353 and Proposed Amendments S. 85 and H.R. 7. February 4 and 5. Available on FRASER.

Committee on Banking, Housing, and Urban Affairs, United States Senate. (1979a) Monetary Policy Improvement Act of 1979, S. 85 and S. 535. February 26, March 26, 27, 28, and May 14. Available on FRASER.

Committee on Banking, Housing, and Urban Affairs, United States Senate. (1979b) Federal Reserve Membership. Amendment No. 398 to S.85, S.353, and H.R. 7. September 26 and 27. Available on FRASER.

Committee on Banking, Housing and Urban Affairs, United States Senate (1998). The Financial Regulatory Relief and Economic Efficiency Act [FRREE] S.1405. March 3 and 10. Available on FRASER.

Staff of the Board of Governors of the Federal Reserve System. (1977) "The Burden of Federal Reserve Membership, NOW Accounts, and the Payment of Interest on Reserves." Available on FRASER.

Published December 12, 2025. Jonathan Rose contributed to this article. Please cite this essay as: Federal Reserve History. "Interest on Reserves." December 12, 2025. See disclaimer and update policy.