FORTUNE — U.S. banks now have $1 trillion at the Federal Reserve. It’s far more than they have ever had before, and it could be a big problem.
And it’s a new one. Before the financial crisis, the amount of cash banks kept idle at the Fed rarely topped $25 billion, which in terms of a multi-trillion dollar banking system is peanuts. But shortly after the start of the financial crisis, as a move to help the banks and save the economy (or perhaps the other way around), the Fed began paying interest on money banks deposited at the Fed.
Money flowed in. It has been rising ever since, but the rate of increase has picked up recently. In the first three months of this year, bank reserves at the Fed rose nearly $200 billion, or 25%, after barely budging in 2012. The amount passed the trillion dollar mark for the first time in April. Still, all that extra cash has done little to boost lending, which dropped in the first quarter.
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“Many institutions have still seen deposits at the central bank balloon as more liquidity has piled up on their balance sheets in recent years,” analysts Marshall Schraibman and Robb Soukup of bank research firm SNL Financial wrote in a report last week.
In the past month or so, interest rates have begun to rise, mostly driven by concern of what the Fed might do and when, now that the economy is improving. But most of that discussion has been around quantitative easing and the Fed’s $3.1 trillion bond portfolio. But what’s not talked about too often is the other hurdle the Fed faces in exiting its stimulus program — how to deal with all the cash the banks have parked at the Fed, and what happens to that money.
In part, the two issues — the bond portfolio and the bank cash — are sides of the same coin. When the Fed buys bonds, it’s handing over money to someone, be it a bank or investors. And some of that money undoubtedly ends up deposited at a bank, which has to put it somewhere. When the Fed decides to sell off its bond portfolio it will be essentially taking that cash back, and, poof, the bank deposits will disappear.
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That’s why some see it as nearly a non-issue. “Reserves don’t even factor into my model,” says Laurence Meyer, a former Fed governor and co-founder of economic forecasting firm Macroeconomic Advisers. “That’s not what causes inflation and not how the Fed stimulates the economy. It’s a side effect.”
Nonetheless, Meyer says Fed economists have drawn up plans to deal with the growing cash hoard. Many think a massive sell-off of the Fed’s bond portfolio might be too disruptive to the bond market, causing rates to skyrocket, slowing the economy and potentially doing massive damage to the banks. As such, the Fed is likely to hang onto its bonds until they mature, which could take years. That means the extra cash at the Fed could be around for long after the economy has fully improved.
That may make it harder to rein in inflation with future interest rate hikes. The Fed currently pays banks an interest rate of 0.25% on their deposits, which now amounts to $2.5 billion a year. Some have already called that a back-door bailout for the banks. Although the banks have to pay some of that money out to the FDIC in order to cover their higher deposit insurance.
If the Fed were to decide to raise interest rates, it would have to increase what it pays the banks on those deposits, which means funneling more government money into the hands of the banks. It’s not clear how that will play politically, especially if it comes at a time when bank profits, and banker bonuses, are soaring again.
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What’s more, at least part of the reason some banks have sharply increased the amount of money they have at the Fed in the past year could have to do with an anticipation that rates will soon rise. Earning a small risk-free interest rate from the Fed may be more attractive for the banks then lending money out at low interest rates or putting reserves in bonds that will drop in value when rates rise. JPMorgan Chase (JPM), for one, has upped the amount of cash it has at the Fed to $214 billion, up from $61 billion a year ago. Cash deposits at the Fed have also jumped for Wells Fargo (WFC), up to $100 billion from $40 billion a year ago. The hope is that at some point those banks will be able to find better uses for that money.
“The reason you worry about it is because of the potential it represents,” says Bob Eisenbeis, a Fed watcher at Cumberland Advisors. “At some point the Fed will have to deal with it.”