Interest on Reserves: How Central Banks Pay Banks to Hold Deposits

Central banks pay interest on reserves (IOR, or IOER for excess reserves) to incentivize banks to hold deposits at the central bank rather than lend them out at lower rates. Since the 2008 crisis, this tool has become the primary mechanism for steering short-term interest rates and anchoring the bottom of the rate structure.

Why Central Banks Started Paying Interest on Reserves

Before October 2008, most central banks did not pay interest on bank reserves. Banks held reserves either to meet regulatory requirements or to maintain liquidity buffers, but earned nothing on them. The Federal Reserve was required by law to compensate banks for required reserves only, and only at rates near zero.

Then the financial system collapsed. The Fed needed to inject massive amounts of liquidity into the banking system—reserves that would grow to trillions of dollars under quantitative easing programs. The problem was simple: banks had trillions of dollars in newly created reserves but earned nothing on them. A rational bank would lend them out at any positive rate, flooding the market with reserves and collapsing short-term interest rates.

To control this flood and maintain some floor beneath overnight rates, Congress passed emergency legislation in October 2008 giving the Federal Reserve authority to pay interest on reserves. The Fed set the federal funds rate target at 0%–0.25% and began paying interest on reserves at a level slightly above zero, creating a natural floor: banks would not lend reserves to other banks at rates lower than what they earned holding reserves at the Fed.

How Interest on Reserves Sets the Rate Floor

The mechanism is elegant. Imagine the Fed pays 4.5% annual interest on reserves. A bank holding excess reserves can earn 4.5% risk-free by doing nothing—simply parking money at the Fed overnight. That same bank will not lend those reserves to another bank at 4.0%, because the borrowing bank would get a worse deal.

Therefore, the overnight federal funds rate (the rate at which banks lend to each other) tends to cluster near or above the IOR rate. If a bank needs reserves, it has two options: borrow from another bank at the federal funds rate, or borrow from the Fed’s discount window (the Fed’s emergency lending facility). If the federal funds rate dips below IOR, banks have an incentive to lend reserves to each other rather than hold them at the Fed—but lenders will demand at least the IOR rate, so the market rate floors there.

This is why interest on reserves is often called the rate floor or the lower bound of the central bank’s operating corridor. It defines the lowest rate at which banks will transact for overnight borrowing and lending.

The Interest Rate Corridor: From IOR to the Discount Rate

To understand modern monetary policy, picture a corridor or channel:

• Floor (IOR): The rate the Fed pays on reserves. Banks have no reason to lend below this rate.
• Target (Federal Funds Rate): The Fed’s desired rate for overnight bank lending, typically set a bit above the floor.
• Ceiling (Discount Rate): The rate the Fed charges for emergency lending. Banks have no reason to borrow at the Fed at rates above what they can earn in the market.

By paying interest on reserves, the Fed created a floor. The distance from floor to target to ceiling ensures orderly money market functioning. During normal times, the federal funds rate hovers near the target. During stress (e.g., during the COVID-19 panic in March 2020), the Fed can widen the corridor or add liquidity to keep the rate from breaching its bounds.

Interest on Reserves vs. Reserve Requirements

Before 2008, central banks relied on reserve requirements—mandatory percentages of deposits that banks had to keep on hand—to constrain money supply growth. But reserve requirements are blunt: they force banks to hold a specific quantity regardless of economic conditions, and they do not directly incentivize behavior at the margin.

Interest on reserves is more flexible. Instead of mandating that banks hold a fraction of deposits, the Fed simply makes reserves attractive to hold by paying interest. A bank that needs capital can lend out its reserves and lose the IOR; a bank flush with deposits will hold reserves to earn the guaranteed rate. This self-balancing mechanism allows the Fed to fine-tune the quantity of reserves in the system through the interest rate alone, without rigid requirements.

This shift explains why most advanced central banks (the Federal Reserve, ECB, Bank of England, Bank of Japan) moved toward zero reserve requirements in the 2010s and 2020s. Reserve requirements became obsolete once interest on reserves proved to be a superior tool.

How the Fed Sets and Adjusts IOR

The Federal Reserve’s policy committee (the Federal Open Market Committee, or FOMC) sets a target range for the federal funds rate—for instance, 4.25%–4.50%. The FOMC then sets the interest rate on reserves near the top of that range (often 5–10 basis points below the upper bound) and sets the discount rate at the top of the range or slightly above.

When the FOMC decides to tighten policy (slow inflation), it raises the federal funds rate target and increases IOR proportionally. When it loosens (support employment during a recession), it lowers both. The spread between IOR and the top of the target range is usually narrow (5–25 basis points) to keep the actual federal funds rate close to the midpoint of the target band.

The Mechanics During a Crisis

In March 2020, when pandemic uncertainty caused banks to hoard cash and the federal funds rate threatened to plummet, the Fed took two actions:

1. Lowered the IOR rate (from 1.60% to just 0.10%) to discourage excess reserve accumulation, freeing banks to lend into the real economy.

2. Expanded quantitative easing to flood the system with new reserves and ensure sufficient liquidity.

By paying a lower rate on reserves, the Fed signaled to banks: “Do not hoard cash; deploy it.” By purchasing bonds, the Fed ensured there was always enough liquidity to meet demand. The two moves worked in concert: QE supplied reserves, while lower IOR encouraged banks to lend them out.

International Adoption and Differences

The Federal Reserve was not alone. After 2008, the ECB, Bank of England, and Bank of Japan all adopted interest on reserves during their own crises. However, the implementation varies:

• The ECB initially paid 0% on reserves (banks were not compensated), then adopted tiered IOR: normal reserves earn one rate, while excess deposits above a threshold earn a negative rate (a penalty). This incentivizes banks not to accumulate surplus reserves.

• The Bank of Japan has used negative rates on some reserve tiers since 2016 to discourage banks from hoarding yen and push them to lend or invest.

• The Bank of England manages its corridor similarly to the Fed, paying interest on reserves while also setting a penalty rate for banks that overdraw.

Negative interest on reserves is controversial. It essentially imposes a cost on banks for holding cash, forcing them to seek returns elsewhere. Banks often pass this cost to depositors via account fees or lower rates on savings. Critics argue this distorts financial incentives, while proponents contend it is necessary to enforce monetary easing when conventional rate cuts are exhausted.

The Inflation-Fighting Shift, 2022 Onward

When inflation accelerated in 2021–2022, central banks began raising interest rates aggressively. The Fed lifted IOR from near zero to over 5% by mid-2023. Higher IOR made reserves more attractive to hold, effectively draining liquidity from the broader economy and tightening financial conditions. Banks with abundant deposits faced a choice: pay depositors more to keep their savings, or watch deposits flee to money market funds and Treasury funds that now offered 5%+ yields due to the higher fed funds rate.

This competitive pressure on deposit rates showed how IOR can ripple through the entire financial system. By setting IOR, the Fed indirectly influences the entire term structure of interest rates, from overnight rates through mortgage rates and beyond.

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