Gains for foreign banks after Fed rate liftoff
When the Federal Reserve decided to raise interest rates by 25 basis points, there was growing concern among many analysts, economists and speculators that the move would hurt emerging market economies.
However, after careful consideration it has now emerged that some of the biggest beneficiaries of the Fed interest-rate hike are foreign-based banking institutions. Various business units of these offshore banks were the recipients of approximately $3.125 billion in interest repayments made by the Federal Reserve Bank. The money that was paid out is known as reserves, and it is deposited and stored at the Federal Reserve Bank. These financial institutions are in charge of approximately 1/7 of total assets held by banks in the United States.
The news from the Fed vis-a-vis interest payments will bode well for these foreign banks since the interest-rate rose from 0.25% to 0.50%. And since it is expected that the Fed will continue raising interest rates throughout 2016 – provided the US economy stays on track towards reaching its 2% inflation objective, and US economic data shows strong growth moving forward – we could be looking at a rate above 1.2% within a year. The rate is otherwise known as the IOER (Interest on Excess Reserves Rate).
The reason why these foreign-based banks enjoy an unequal share of the interest repayments that are made by the Fed are directly attributed to the disproportionate share of total reserves held with the Fed by these foreign banks.
Federal Reserve Bank data reflects that American agencies and branches of foreignbased banks held over $880 billion in reserves by June 30, 2015. This figure accounts for some 35% of all reserves. If we extrapolate to the beginning of December 2015, it is clear that foreign financial institutions had deposited for safekeeping some $1.2 trillion with the Federal Reserve Bank. This accounts for almost half of total reserves (47% in total). Between June and November 2015, the average cash assets and other reserves held by foreign banks in the United States hovered around $1.1-1.2 trillion per month. This figure includes balances due from financial institutions, balances owing from Federal Reserve Banks, vault cash, cash in collection, etc.
Banc De Binary analysts point out that the reason why foreign banks have an unusually greater quota of reserves with the Fed is a combination of incentivised schemes and financial regulations. The FDIC (Federal Deposit Insurance Corporation) receives revenues in the form of premiums from US chartered banks. This also includes foreign banking entities. The exact amount that these institutions receive ranges from 0.05% all the way up to 0.35%, contingent upon the asset holdings of these banks. The calculations are complex; suffice it to say that it is a combination of cash reserves less various capital measures. There are scores of financial entities that are exempt from making payment to the FDIC, notably those banking institutions that do not take deposits, as well as American financial operations that are incorporated offshore, and whose US-based financial institutions do not accept deposits.
It is entirely possible for US-based banks and foreign-based banks to borrow substantial sums of money overnight at really low rates of interest. These are known as short-term interest rates, and the funds can be kept at the Fed for a higher rate. The spread is the interest rate differential between the overnight borrowing rate and the rate these banks receive when depositing with the Fed. Not all foreign-based banking institutions have to pay the fees levied by the FDIC.
As a case in point, prior to the 0.25% rate hike, this fee paid by banks for overnight borrowing in the short-term Federal Funds Market was 0.13%. However the earnings on reserves amounted to 0.25%. The spread was therefore 0.12% by comparison; US-based banks received a far lower spread of just 0.05%. Now that the Fed has hiked interest rates to 0.50%, the overnight borrowing rate is 0.35% and the amount that they receive on earnings is 0.50%. This leaves a spread of 0.15% for foreign-based banks. However, the differential is substantially smaller for USbased banks which now only receive approximately 0.08%.
The intricacies of international financing and regulation between retail banks, wholesale banks and the Federal Reserve Bank are complex. The spread is often offset in foreign markets, and regulatory treatment varies from one market to another.
As can be seen from the increasing spread for foreign banks after the Fed rate hike, there will be tremendous interest in using the Fed to pay more to foreign-based banks now that the interest-rate has been increased to 0.50%. According to those in the know, the 25-basis point rate hike will cost the US government approximately $13 billion in annual repayments to foreign banks. Of course reserve levels need to be kept at their status quo, ceteris paribus. There is a disproportionate advantage being given to foreign banks after the Fed rate hike. Very little news has been circulating in the media about the effect of a rate hike, while most of the attention is centred on options trading, with currency speculators having a field day, notably with the emerging market currencies.