The payment of interest on reserves is supposed to put a floor beneath the federal funds rate. Since banks can lend to one another overnight at the federal funds rate, they have a choice. The bank can either lend excess reserves to another bank at the federal funds rate or they can hold the reserves at the Federal Reserve and collect the interest the Fed pays on reserves. In theory, this means that the federal funds rate should never go below the interest rate on reserves. The reason is simple. No bank should have the incentive to lend at a lower rate than they would receive by not lending.
However, the effective federal funds rate has been consistently below the interest rate on reserves. How can this be so? Marvin Goodfriend explains:
The interest on reserves floor for the federal funds rate failed, and continues to fail to this day, because non-depository institutions (such as government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and Federal Home Loan Banks (FHLBs)) are authorized to hold overnight balances at the Fed, but are not eligible to receive interest on those balances. Hence, the GSEs and FHLSs [sp] have an incentive to try to earn interest on their overnight balances at the Fed by lending them to depositories eligible to receive interest on their reserve balances. The federal funds rate is thereby driven below interest on reserves to the point that depositories are willing to borrow from the GSEs and the FHLBs, deposit the proceeds at the Fed, and earn the spread between interest on reserves and the federal funds rate.