Fed Rate Hike Raises Costs of Funding Global Commerce

The Federal Reserve on Wednesday (Sept. 16) raised the target range for the federal funds rate by a quarter percentage point to 3.75% to 4% , saying inflation remains elevated. In its accompanying implementation decision, the Fed raised the interest rate paid on reserve balances to 3.90% from 3.65% , effective Thursday. For banks, the decision reaches beyond the rates charged on loans and paid for funding. The Fed’s move also changes the economics of liquidity, including some of the money institutions position so they can execute payments in different currencies and jurisdictions. Correspondent banking’s an example here. Most cross-border payments still rely on correspondent relationships. As detailed here by the Bank for International Settlements, the system is a network in which commercial banks transact through nostro and vostro accounts. Banks and intermediaries make a sequence of account updates, potentially including foreign exchange conversion when the sender and recipient use different currencies. Liquidity must be available when those payments settle. In some arrangements, that requires prefunding. Prefunding means maintaining balances in the accounts needed to make payments before those payments are executed. An examination of cross-border and multicurrency payment systems explains why: A settlement institution may be unable or unwilling to extend intraday liquidity to a foreign participant or provide liquidity in a foreign currency. Banks therefore can keep balances in the relevant accounts in advance. The arrangement reduces the risk that a payment will be delayed or fail because funds are unavailable. It carries a financial cost, however. At least some cash sits idle, and the idle buffer balances as one potential cost of prefunding. It’s money that could be put to work elsewhere. The Fed’s rate increase does not mean every prefunded balance suddenly costs a bank an additional 25 basis points, in lockstep with Wednesday’s boost. Correspondent balances may earn interest, currencies carry different interest rates and banks fund their positions differently. What has changed is the return available on an alternative use of dollar liquidity. The Fed says a bank is unlikely to lend to another bank or customer at a rate below what it can earn on reserve balances at the central bank. Its explanation of monetary policy transmission says changes in the rate paid on reserves provide an incentive for the federal funds rate to move with the Fed’s target. As of Thursday, the interest rate on those reserve balances will be 3.90%. For low-yielding or noninterest-bearing dollar balances held elsewhere for payment purposes, the opportunity cost consequently rises. A bank still needs the liquidity to execute its customers’ payments, but money earmarked for that purpose may earn less than it could in reserve balances or other short-term assets.