There seems to be a little confusion about excess reserves held by commercial banks.  The Federal Reserve started paying interest on excess reserves right around the time the economic crisis became noticeable.  It has been written by some analysts that the banks started holding excess reserves because the Fed is paying interest.

This is bad analysis, as the reason for the boom in excess reserves is probably not due to the interest paid.  The Fed is only paying one quarter of a percent on excess reserves.  Bernanke, in his recent speech in Jackson Hole, Wyoming, said that reducing the rate paid on excess reserves is a possible future weapon for fighting a bad economy (he may have used the term “disinflation” instead of bad economy).  But even Bernanke admitted that it might not have much effect.

The Fed is only paying .25% interest.  They could lower it to zero and it probably won’t make much difference.  Now, the Fed could charge a fee (a negative interest rate), but this was not discussed by Bernanke.

The most likely reason the banks are holding these large amounts of excess reserves is because of uncertainty.  The uncertainty just happened to coincide with interest paid on excess reserves and a more than doubling of the monetary base.  It is not necessarily all coincidence, but let’s not confuse cause and effect.  Just because the Fed started paying interest on excess reserves around the same time that excess reserves went way up, doesn’t mean that one thing caused the other.  The banks made a lot of bad loans in the past and they are afraid of making loans now.  They are afraid that people will default, so they are being very careful who they lend money to.  Reducing the rate to zero on excess reserves will not change these circumstances.