The payment of interest on required reserve balances, or reductions in reserve requirements, would lower the revenues received by the Treasury from the Federal Reserve. The extent of the potential revenue loss, however, has fallen over the last decade as banks have increasingly implemented reserve-avoidance techniques.

A focus on central bank credit also makes clear that paying interest on reserves is more important than is commonly appreciated. The prohibition of interest on central bank deposits, as in the U.S., greatly enhances the demand for daylight credit, in the sense that larger overnight balances act as substitutes for daylight overdrafts. As a result, limitations on central bank credit extension would be less costly if reserves earned interest.

The Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.

As we have previously testified, unnecessary legal restrictions on the payment of interest on demand deposits at depository institutions and on balances held at Reserve Banks distort market prices and lead to economically wasteful efforts by depository institutions to circumvent these artificial limits. In addition, authorization of interest on all types of balances held at Reserve Banks would enhance the toolkit available for the continued efficient conduct of monetary policy. And the ability to pay interest on a variety of balances, together with increased authority to lower or even eliminate reserve requirements, could allow the Federal Reserve to reduce the regulatory and reporting burden on depository institutions of reserve requirements.

Although paying interest on reserves would yield significant benefits, even greater efficiencies and regulatory burden reduction might be realized by substantially reducing, or even eliminating, reserve requirements.

I welcome the opportunity to testify on behalf of the Federal Reserve Board on proposals in S. 1405 to allow the payment of interest on demand deposits and on the required reserve balances of depositories at the Federal Reserve. The Federal Reserve strongly supports these measures. We have commented favorably on such proposals on a number of previous occasions over the years, and the reasons for those positions still hold today. We also believe the legislation should include a provision to allow the Federal Reserve to pay interest on excess reserves.

These legislative proposals are important for economic efficiency: Unnecessary restrictions on the payment of interest on demand deposits and reserve balances distort market prices and lead to economically wasteful efforts to circumvent them.

The ability to pay interest on excess reserves would provide an additional tool that could be used for monetary policy implementation, but one that might not need to be used, if interest on required reserve balances and demand deposits resulted in a sufficient boost to the level of those balances. Even if not used immediately, it is important that the Federal Reserve have the full range of tools available to other central banks, given the inventiveness of our financial markets and the need for the Federal Reserve to be prepared for potential developments that may not be immediately visible.

For banks, interest on demand deposits will increase costs, at least in the short run. Larger banks and securities firms may also lose some of the fees they currently earn on sweeps of business demand deposits. The higher costs to banks will be partially offset by interest on reserve balances, and over time, these measures should help the banking sector attract liquid funds in competition with nonbank institutions and direct market investments by businesses.

Eliminating price distortions on demand deposits and on required and excess reserve balances would spare the economy wasteful expenditure, increase the efficiency of our financial markets, and facilitate the conduct of monetary policy.

The payment of interest on reserve balances would tend to reduce the revenues received by the Treasury from the Federal Reserve, while the payment of interest on demand deposits would increase those revenues. Treasury revenues would be directly reduced by the payment of interest on existing reserve balances. However, there would be some offset to this direct revenue loss. The level of reserve balances would rise because of the interest payments, and the Federal Reserve would therefore be able to increase its holdings of government securities.