Last week, I wrote about how the Federal Reserves near-zero interest rate policy is lining the pockets of the country's megabanks like Bank of America (NYSE: BAC ) in spite of the savings accounts of everyday individuals.
Today, I'll go a step farther. Another small change to the mechanics of the Fed Funds Market created a hugely profitable arbitrage trade for the world's largest banks and, in essence, funneled tax payer dollars to overseas banks.
And I'll explain why this is a good thing.
"Interest on excess reserves"
On October 6, 2008, the Federal Reserve announced it would begin paying interest to banks on any excess reserve balances those banks held with the Fed.
This change in policy to paying "interest on excess reserves" (IOER), coupled with other liquidity inducing measures like opening the discount window, immediately back-stopped the quickly malfunctioning overnight lending system.
Banks use overnight lending to both manage liquidity (by borrowing) and also turn a small profit on otherwise zero-yield assets (by lending). At the height of the crisis, banks didn't trust that other banks would survive to pay back the loans the following day, so the market essentially dried up.
By allowing banks to borrow directly from the Fed, banks now had a life line to access the cash they needed to open for business the following day. By instituting IOER, the Fed was also able to provide yield to the banks to at least partially offset the interest income typically earned from overnight lending.
Consequences -- intended or not
Like any other change in a system this complex, there were consequences, some intended, some not.
For one, the size of the Fed Funds Market shrank dramatically overnight on October 8, 2008, and it has been trending downward since.
This change makes sense logically. Instead of lending money overnight to other financial institutions, banks can now simply collect interest from the Fed thanks to IOER. Traditional banks and bank holding companies have reduced their presence in the market from more than half to about 25% as of the end of 2012, according to the New York Fed.
And its not the giant government-sponsored mortgage entities, Fannie Mae (NASDAQOTH: FNMA ) and Freddie Mac (NASDAQOTH: FMCC ) , picking up the slack either, even though these giants are ineligible for IOER.
According to the New York Fed, its a lesser-known but crucially important institution called the Federal Home Loan Bank. Today, these institutions represent about 75% of the Fed Funds market, up from just 40% as recently as 2006 (click here for a very good interactive chart of this change).
Organized into 12 "banks" across the U.S., these institutions are owned by and serve banks within each geographic region. Instead of financing loans directly to consumers, these banks make loans to commercial and retail banks secured by the bank's loan portfolio. This buffer helped the Federal Home Loan Banks navigate the financial crisis much easier than Fannie, Freddie, or other commercial and retail banks.
The Federal Home Loan Banks are not eligible for IOER, so they remain in the Fed Funds market in search of yield and to serve their member banks.
Here is where it gets really interesting
When it comes to making a profits, banks are clever, and they'll take what they can get. This is no exception.
Let's take Winston-Salem, North Carolina-based BB&T (NYSE: BBT ) as an example. BB&T can go to the Fed Funds market and borrow some amount of overnight money from its constituent Federal Home Loan Bank in Atlanta.
BB&T then simply deposits that money with the Fed as an excess reserve. Thanks to the Fed's generous rates on those excess reserves being greater than the rate being charged by the Federal Home Loan Bank, BB&T is able to turn a nice profit every night as CEO Kelly King lays in bed dreaming.
The primary limitation for U.S. banks lies in some complex accounting rules outside the scope of this article. The bottom line is that U.S. banks can't put too much money into this arbitrage trade without bumping into problems with their capital ratios.
For foreign banks, though, the rules are different. These banks and bank holding companies operating in the U.S. can skirt the capital rule issue, borrow money on the Fed Funds market, and then collect the spread provided by the interest on excess reserves.
And that's why foreign banks have consistently borrowed more from the Fed Funds market than domestic banks. In the first quarter of 2008, foreign and domestic banks borrowed from this market at essentially a 1:1 ratio. Since Q4 of 2008 though, the foreign banks have borrowed more by a 1.5:1 ratio.
Everyone take a breath; this is no cause for alarm
In my view, the benefits of this dynamic exceed any perceived costs. The Fed's actions during and after the crisis were absolutely needed to save a financial system on the brink of collapse. By stepping into the overnight lending market, the Fed stabilized an essential and critical source of liquidity for the entire economy.
And if you're concerned about your dollars subsidizing the profits of foreign banks, you too can rest easy. The entire Fed Funds market in the fourth quarter of 2012 was just a hair over $60 billion.
That number sounds like a lot to everyday investors like you and me, but in the world of global finance, it's not even a drop in the bucket. Bank of America alone is 35 times the size of the entire Fed Funds market.
Interest on excess reserves and the consequences it brought are important, though. It is in the relatively small issues, changes, rules, and mechanisms that we can really get a glimpse of just how complex this financial system really is. It's also a indication of just how difficult it's going to be for the Fed to unwind all of its crisis-era programs and policies.
Tired of the complexity of modern banks?
Many investors are terrified about investing in big banking stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.