The Great Divorce: The FED’s Move to a Floor System and the Implications for Bank Portfolios

Abstract

The Federal Reserve switched from using a corridor operating system to using a floor operating system in late 2008. By design, a floor system eliminates the opportunity cost to a bank of holding reserves, allowing a central bank to use its balance sheet as an independent tool of monetary policy. Making the demand for bank reserves perfectly elastic is therefore a feature, not a bug, of a floor system. Some observers worry, however, that this feature may adversely affect asset allocation in bank portfolios such that banks underinvest in loans. If this is the case, broader money and credit creation may be less under the Fed's floor system than they would have been otherwise. This paper investigates this possibility by taking a close look at bank portfolios and assessing whether any changes since 2008 can be contributed to the Fed's floor system. The paper does find significant changes in bank portfolio allocations over the past decade and is able to trace much of the shift to the Fed's floor system.