Interest on Reserve Balances

The Interest on Reserve Balances (IORB) is the rate the Federal Reserve pays on cash balances that banks hold in their reserve accounts at the Fed. Introduced permanently in 2008 and refined continuously since, IORB became the true floor of the federal-funds-rate corridor—the price below which overnight-lending between banks cannot fall. By paying interest on reserves, the central bank transformed how it implements monetary policy, shifting from directly controlling the money supply to anchoring interest rates through pricing.

The pre-IORB regime

Before 2008, the Federal Reserve did not pay interest on reserves. Banks held reserves because the law required it; there was no compensation. The Fed controlled short-term interest rates by adjusting the money supply through open-market operations—buying and selling securities to tighten or loosen liquidity.

This system worked well in normal times. Controlling the supply of reserves automatically changed their scarcity value and thus the federal-funds-rate. But it had a fatal flaw during crises. When the central bank injected massive amounts of liquidity (as it did in 2008), there was so much reserve supply that the federal funds rate collapsed towards zero, even if the Fed wanted rates to stay above zero. Reserves became worthless; banks had no incentive to hold them rather than deploy them, and the interest rate floor disappeared.

The innovation: paying interest on reserves

The solution was to introduce a price floor. If the Fed paid interest on reserves, banks would not lend overnight in the interbank market below that rate—otherwise they would simply hold reserves and earn the Fed’s interest. This transformed reserve-requirements from a cost (money trapped and earning nothing) into an asset (money earning a known return). The Fed could now inject or withdraw liquidity without fear of rates collapsing or soaring.

Congress authorised the Fed to pay interest on reserves in 2006, though the Fed did not use the power until late 2008, at the height of the financial crisis. The rate was initially set very low (0.25 per cent), but the mechanism was clear: IORB became the floor.

How it anchors the federal funds rate corridor

The federal funds target rate is now implemented as a corridor:

• Floor (IORB): the interest rate paid on reserves. No bank will lend overnight below this, because doing so forfeits the guaranteed Fed return.
• Ceiling (discount rate): the rate at which the Federal Reserve will lend to banks through the discount-window-lending facility. No bank will borrow in the market above this, because it can borrow from the Fed instead.
• Target range: the federal funds target, set midway between the floor and ceiling (e.g., 4.50–4.75 per cent).

When the Federal Reserve wants to lower interest rates, it cuts IORB and the discount rate symmetrically. Banks earn less on reserves, so they are more willing to lend them out. When it wants to raise rates, it increases IORB and the discount rate. Banks hoard reserves to earn the higher return. The overnight rate (the actual federal funds rate) gravitates towards the target as banks balance lending against holding reserves.

This system is elegant precisely because it relies on incentives, not quantity controls. The Fed does not need to forecast how much liquidity the market needs; the corridor pricing does the work.

The floor becomes the ceiling in low-rate environments

One subtle consequence of IORB: as the target rate falls towards zero, IORB falls with it. In 2020–2021, with the target at 0–0.25 per cent, IORB was effectively zero. Banks earned nothing on reserves. The corridor mechanism still worked, but only barely: the lower bound on rates had been reached. For nearly two years, the federal funds rate was essentially pinned at the floor by the absence of any scarcity value on reserves.

This changed the transmission of monetary policy. Historically, monetary policy worked through the interest rate channel: as the Fed raised short rates, long-term bond yields rose, borrowing became more expensive, investment and consumption fell. But at zero rates, this channel broke. To stimulate the economy, the Fed had to resort to quantitative-easing (buying long-term securities) and forward-guidance (promising to keep rates low). This was a regime change that IORB alone could not implement.

The reverse repo market and the spread

A related innovation emerged in the 2010s: the reverse repurchase agreement (reverse repo) market. When IORB was nearly zero but short-term funding markets were slightly higher, money market funds and other non-bank investors would lend to the Fed in the reverse repo market instead of holding deposits earning nothing. The Fed set a reverse repo rate (always slightly below IORB) to manage this.

By 2022–2023, reverse repo volumes had soared to $2+ trillion, because the spread between IORB and reverse repo rates created a profit opportunity for institutional investors. This was a sign that the banking system had developed structural excess reserves; there was so much central-bank-injected liquidity that it had nowhere to go except the Fed’s own reverse repo window.

IORB in the 2022–2023 rate cycle

When the Federal Reserve began raising rates sharply in 2022 to combat inflation, IORB rose in lockstep. By mid-2023, IORB was around 5.25 per cent. Banks faced a new challenge: as IORB rose, the opportunity cost of lending out reserves increased. Banks began competing fiercely for deposits to fund loans, offering high deposit rates. This put pressure on smaller banks that could not easily raise deposits. When a few mid-sized banks failed (notably Silicon Valley Bank in March 2023), it was partly because they had not kept deposit rates competitive, losing deposits to larger competitors and money market funds. The high IORB rate was the culprit, indirectly.

In response, the Federal Reserve created a Bank Term Funding Program to lend to banks against collateral at penalty rates, stabilising the banking system. But the episode illustrated that IORB, while elegant in theory, creates real tensions in the banking system when raised aggressively. Banks must pass on high rates to depositors or lose them; if loans are locked in at low rates, net interest margins compress.

See also