To induce banks to hold more than $1.5 trillion in funds desired by the Fed to finance its credit policy, in 2008 the Fed began paying interest on excess as well as required reserves.Receipt of these interest payments gave banks an incentive to borrow funds from other sources (at a lower interest rate) to hold on reserve at the Fed.These sources of funds were the government-sponsored housing finance institutions - the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC).

Banks thereby borrow from FNMA and FHLMC to add to their excess reserves holdings with the Fed at a slightly higher interest rate.In this way, the Fed effectively pays interest on reserves that banks split with FNMA and FHLMC.As a result, the Fed's policy of paying interest on excess reserves effectively grants an estimated $1 billion per year in subsidies to banks and to these two government-sponsored housing finance institutions.

How does interest on excess reserves reduce bank lending to households and firms?