Interest on reserves represents the rate of return on a riskless overnight deposit at the Fed.7 Accordingly, the interest rate paid on reserves represents the sure return a bank can earn and therefore the opportunity cost for the bank to make an alternative investment, such as a loan or the purchase of a security. Theoretically, if all money market participants had access to deposits earning the IOER rate, the IOER rate should set a minimum rate – or floor, so to speak – on short-term interest rates, as there would be no incentive for institutions to make loans to any institution at a lower rate. Even in a market without universal access to IOER, depository institutions with access to it could borrow funds or take deposits from institutions that cannot earn it, then leave funds invested at the IOER rate until there’s no further economic advantage to borrower or lender. Competition among banks that can earn IOER would thus pull up other money market rates close to the IOER rate. Money market dynamics in recent years generally reflect these changes. In a world with significantly elevated reserve balances and a ¼ percent interest rate paid on those balances, IOER has kept the federal funds rate and other money market rates at positive levels within the FOMC’s zero to ¼ percent target range.
Norman T L Chan: 3Ds – an era of awakening? Speech by Mr Norman T L Chan, Chief Executive of the Hong Kong Monetary Authority, at the 4th Santander International Banking Conference: “A Global Financial System for a Global Economy”, Madrid, 18 October 2011. *  *  *  Good afternoon ladies and gentlemen, I am honoured to receive the invitation to attend and speak at the 4th Santander International Banking Conference today. It is only a few short years ago that the world economy was shaken to its core by the Global Financial Crisis. That we again face the threat of profound and traumatic disruption so soon is a measure of the urgency that governments must employ to correct the structural imbalances necessary to get the economy back on song for the long term. Today I want to take up a little bit of your time explaining what I see as fundamental to righting the ship so that it can survive in the roughest of seas. Collapse of Bretton Woods System After World War II, the World’s Superpowers tried to maintain a system of semi (or quasi) Gold Standard in which major currencies were fixed to the US dollar, which was in turn fixed to Gold at $ an ounce. This global monetary system was basically a fixed rate regime, which imposed an external discipline to restrain monetary expansion globally.