Reserve requirements history, current practice, and potential reform


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Reserve requirements history, current practice, and potential reform

  1. 1. Reserve Requirements: History, Current Practice, and Potential Reform Joshua N. Feinman, of the Board’s Division of poraneous link between reserves and M1 deposits. Monetary Affairs, prepared this article. Jana Although the Federal Reserve is no longer pursuing Deschler and Christoph Hinkelmann provided this type of short-run control of money, reserve research assistance. requirements still play an important role in the conduct of open market operations, which are now Laws requiring banks and other depository institu- aimed at influencing general monetary and credit tions to hold a certain fraction of their deposits in conditions by varying the cost and availability of reserve, in very safe, secure assets, have been a part reserves to the banking system. By helping to of our nation’s banking history for many years. The ensure a stable, predictable demand for reserves, rationale for these requirements has changed over reserve requirements better enable the Federal time, however, as the country’s financial system Reserve to achieve desired reserve market condi- has evolved and as knowledge about how reserve tions by controlling the supply of reserves; in so requirements affect this system has grown. Before doing, they help prevent potentially disruptive fluc- the establishment of the Federal Reserve System, tuations in the money market. reserve requirements were thought to help ensure Reserve requirements are not costless, however. the liquidity of bank notes and deposits, particu- On the contrary, requiring depositories to hold a larly during times of financial strains. As bank runs certain fraction of their deposits in reserve, either and financial panics continued periodically to as cash in their vaults or as non-interest-bearing plague the banking system despite the presence of balances at the Federal Reserve, imposes a cost on reserve requirements, it became apparent that the private sector equal to the amount of forgone these requirements really had limited usefulness as interest on these reserves—or at least on the frac- a guarantor of liquidity. Since the creation of the tion of these reserves that banks hold only because Federal Reserve System as a lender of last resort, of legal requirements and not because of the needs capable of meeting the liquidity needs of the entire of their customers. The higher the level of reserve banking system, the notion of and need for reserve requirements, the greater the costs imposed on the requirements as a source of liquidity has all but private sector; at the same time, however, higher vanished. Instead, reserve requirements have reserve requirements may smooth the implementa- evolved into a supplemental tool of monetary tion of monetary policy and damp volatility in the policy, a tool that reinforces the effects of open reserves market. market operations and discount policy on overall The Federal Reserve could resolve this policy monetary and credit conditions and thereby helps dilemma by paying interest on required reserves, or the Federal Reserve to achieve its objectives. at least on the part of these reserves that banks While useful as an auxiliary policy tool, reserve would not hold were it not for legal requirements. requirements also have important implications for Paying an explicit, market-based rate of return on the efficacy of the Federal Reserve’s primary tool, these funds would effectively eliminate much of open market operations. In the early 1980s, for the costs of reserve requirements without jeopardiz- example, when open market operations were ing the stable demand for reserves that is needed geared toward fostering fairly precise, short-run for open market operations and for the smooth control of narrowly defined money (M1), reserve functioning of the reserves market. requirements were designed to help facilitate this The Federal Reserve Board has long supported control by establishing a relatively stable, contem- legislation that would explicitly allow interest to be
  2. 2. 570 Federal Reserve Bulletin June 1993 paid on the balances that depositories are required to maintain reserves against transaction deposits, to hold in reserve—though not on the cash they which include demand deposits, negotiable order hold in their vaults, which is assumed to be held of withdrawal accounts, and other highly liquid primarily to meet customer needs—but to no avail.1 funds.2 Reserves against these deposits can take the Opposition has typically centered on the adverse form either of currency on hand (vault cash) or implications such a move would have for Treasury balances at the Federal Reserve. The Federal revenue. If the Federal Reserve paid interest on Reserve may vary the percentage of transaction required balances, its net earnings would decline, deposits that must be kept in reserve, but only and because it turns the vast majority of its earn- within fairly narrow limits prescribed by law; ings over to the Treasury, the Treasury’s revenues requirements may also be imposed on certain types would decline as well. On the other hand, eliminat- of nontransaction accounts, though again only ing the costs of reserve requirements would remove within specified limits.3 At present, the required one government-mandated impediment to deposit- reserve ratio on nontransaction accounts is zero, taking and lending through the banking system. while the requirement on transaction deposits is Recently, the costs of depository intermediation 10 percent, which is near the legal minimum. have risen sharply because of higher deposit insur- Most depositories are able to satisfy their entire ance premiums, stiffer capital requirements, more reserve requirement with vault cash, which they stringent standards for interbank lending, and other hold primarily to meet the liquidity needs of their regulatory burdens. Much of these increased costs customers and would likely hold even in the have likely been passed on to the customers of absence of reserve requirements. For these institu- depositories in the forms of higher loan rates and tions, reserve requirements are essentially costless. lower deposit rates; paying interest on reserves About 3,000 depositories, however, have vault cash would be one way of countering some of these holdings that are insufficient to satisfy their entire government-mandated increases in costs. reserve requirement. To meet their requirements, these institutions must also maintain deposits, called required reserve balances, at the Federal BASIC CONCEPTS AND CURRENT RULES OF Reserve. RESERVE REQUIREMENTS Under current regulations, all depository Reserve Requirements as a Tax institutions—commercial banks, savings banks, thrift institutions, and credit unions—are required Some uncertainty exists as to whether the Federal Reserve Act permits interest to be paid on reserves. In fact, the Federal Reserve has never actually paid 1. See, for example, ‘‘Statement by Arthur F. Bums, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions of the Committee on Bank- ing, Housing, and Urban Affairs, U.S. Senate, June 20, 1977,’’ Federal Reserve Bulletin, vol. 63 (July 1977), pp. 636–43; ‘‘State- 2. For a formal definition of depository institutions and transac- ment by J. Charles Partee, member, Board of Governors, before the tion accounts, see Federal Reserve Regulation D (Reserve Require- Subcommittee on Financial Institutions Supervision, Regulation ments of Depository Institutions), sections 204.1 and 204.2. and Insurance of the Committee on Banking, Finance and Urban 3. At present, required reserve ratios may be set between 8 per- Affairs, U.S. House of Representatives, October 27, 1983,’’ Federal cent and 14 percent on transaction accounts in excess of $46.8 mil- Reserve Bulletin, vol. 69 (November 1983), pp. 840–52; and lion, and between 0 and 9 percent on nonpersonal savings deposits, ‘‘Statement by Alan Greenspan, Chairman, Board of Governors of nonpersonal time deposits with original maturities of eighteen the Federal Reserve System, before the Subcommittee on Domestic months or longer, and net Eurocurrency liabilities. Transaction Monetary Policy of the Committee on Banking, Finance and Urban deposits of less than $46.8 million, in the so-called low reserve Affairs, U.S. House of Representatives, February 19, 1992,’’ Gov- tranche, are reservable at 3 percent, while the first $3.8 million of ernment Printing Office, Serial No. 102-98 (1992), pp. 42–43. The transaction deposits at each depository are exempt from reserve Federal Reserve has also requested the lifting of the prohibition on requirements altogether. The Federal Reserve cannot alter the cut- the payment of interest on demand deposits. See, in particular, the offs for the low reserve tranche or the exemption, which are statement by J. Charles Partee, October 27, 1983. adjusted each year according to a formula provided by law.
  3. 3. Reserve Requirements: History, Current Practice, and Potential Reform 571 interest on required reserve balances.4 Requiring medium-sized businesses, have few alternatives depositories to hold idle, non-interest-bearing bal- outside of the depository system, these borrowers ances is essentially like taxing these institutions in may ultimately bear some of the burden of the an amount equal to the interest they could have reserve tax in the form of higher costs of credit. earned on these balances in the absence of reserve requirements. This forgone interest, or reserve ‘‘tax,’’ directly affects only the depository system Current Estimates of the Reserve Tax and its customers, and not other parts of the finan- cial system. Hence, it creates an artificial incentive Table 1 presents estimates of the current dollar for depositors and borrowers to bypass the deposi- magnitude of the reserve tax. In the fourth quarter tory system, and in so doing it may redirect credit of 1992, the required reserve balances of all deposi- flows in ways that impair the efficiency of resource tories totaled $231⁄2 billion. Because many of the allocation. In particular, by distorting the relative financial transactions in our economy flow through price of transaction accounts at depositories, the these reserve accounts, even in the absence of reserve tax may induce a smaller level of transac- reserve requirements depositories would likely hold tion services than what would be ideal for the some balances at the Federal Reserve as a buffer functioning of the economy. The reserve tax also against the normal uncertainties surrounding pay- creates an incentive for depositories to expend ment flows. Thus, $231⁄2 billion should be consid- resources trying to minimize required reserves by ered an upper bound on the amount of balances fashioning new financial products aimed solely at truly idled by reserve requirements in the fourth delivering transactions services without creating quarter of 1992. Even if banks had invested all of reservable liabilities. these funds, moreover, the gains would probably As is true for most taxes, determining precisely not have been large because short-term interest who bears the burden of the reserve tax is difficult. rates are currently at relatively low levels. Using a That determination depends in a complicated way federal funds rate of 3 percent as a proxy for the on the degree of competitive pressure in the mar- potential earnings rate on idle balances, the lost kets for deposits and loans and the associated sensi- interest income due to reserve requirements totals tivities of borrowers, lenders, and depositories to only about $700 million, at an annual rate, based changes in prices and interest rates. One thing is on $231⁄2 billion of balances. About $600 million certain, however: Depositories and their sharehold- of this would have accrued to commercial banks ers do not bear all of the costs but rather pass at and their customers; even in the unlikely event that least some of them on to their customers in the banks were able to retain all of this increased forms of lower deposit rates and higher loan rates. revenue, it would have boosted their pretax return In compensating-balance arrangements, for exam- on assets for 1992 by only about 2 basis points ple, in which customers maintain non-interest- compared with an actual pretax rate of return on bearing deposits as compensation for bank ser- assets of a little more than 130 basis points. vices, the customers typically ‘‘pay’’ the reserve On an after-tax basis, the earnings would be even tax by holding additional balances. Similarly, to the smaller because depositories and their customers extent that some borrowers, such as small and would have to pay extra taxes on this additional income. Regardless of the precise figure, however, 4. The Federal Reserve Board has, however, at least in the past, taken the position that it has the discretion to pay interest on 1. Burden of reserve requirements, 1992:Q4 reserves, though individual members of the Congress opposed such Billions of dollars payments at the time of the enactment of the Federal Reserve Act Type of Required Forgone in 1913 and again as recently as 1978. For details on a Federal institution reserve balances interest Reserve proposal to pay interest on required reserve balances in 1978, see Federal Reserve Bulletin, vol. 64 (July 1978), All depositories . . . . . . . . . . . . . 23.5 .7 pp. 605–10. For congressional reaction to this proposal, see, ‘‘Mone- Commercial banks . . . . . . . . . . . 21.1 .6 tary Control and the Membership Problem,’’ Hearings before the Thrift institutions . . . . . . . . . . . . 2.4 .1 Committee on Banking, Finance and Urban Affairs on H.R. 13476, H.R. 13477, H.R. 12706, and H.R. 14072, 95 Cong. 2 Sess. U.S. 1. Forgone interest is annualized, based on a federal funds rate of House of Representatives (GPO, 1978), p. 781. 3 percent.
  4. 4. 572 Federal Reserve Bulletin June 1993 if the Federal Reserve paid interest on all required and New England entered into voluntary redemp- reserve balances, the private sector would enjoy a tion arrangements as early as 1820. Under these net increase in after-tax income, whereas the Trea- arrangements, one bank agreed to redeem another sury would see its net revenues reduced. Of course, bank’s notes at par, provided that the issuing bank if interest rates were higher, the burden of reserve maintained a sufficient deposit of specie (gold or its requirements and the private-sector cost savings equivalent) on account with the redeeming bank as and government revenue losses stemming from backing for the notes. In essence, these deposits paying interest on required reserve balances would represented the first required reserves. The primary be commensurately larger than the amounts shown purpose of these reserves was to increase the in table 1. The distortions to resource allocation liquidity of bank notes by ensuring their convert- would be more pronounced as well. Indeed, the ibility into specie. Although in subsequent years burden of reserve requirements has, at times, been some states began to require banks to maintain considerably larger than it is now, as a result of reserves against their notes, and a few even began both higher interest rates and higher reserve to require reserves against deposits, most states still requirements. had no legal reserve requirements when the Civil Because reserve requirements are a tax on the War broke out in 1861. private sector that may distort the optimal alloca- tion of resources in the financial sector, the ques- tion arises as to why these requirements were The National Bank Era imposed in the first place. The next section traces the historical evolution of reserve requirements and Reserve requirements were first established at the their rationales to see how our current system national level in 1863 with the passage of the developed. Subsequently, several options for National Bank Act. This act provided banks an reforming the current system to eliminate the opportunity to organize under a national charter reserve tax without jeopardizing the effective con- and created a network of institutions whose notes duct of monetary policy are analyzed. could circulate more easily throughout the country. In exchange for this charter, banks had to hold a 25 percent reserve against both notes and HISTORICAL REVIEW OF RESERVE deposits—a much higher requirement than that REQUIREMENTS AND THEIR RATIONALES faced by most state banks. Although banks in ‘‘redemption’’ cities—designated in the act as cities Reserve requirements have played a part in our where notes were likely to accumulate for nation’s financial system from the earliest days— redemption—had to hold reserves entirely in the long before the creation of a national currency or a form of ‘‘lawful’’ money (specie or greenbacks), central bank. banks outside these cities could maintain 60 per- cent of their reserves in interest-bearing balances at Early State Laws and Practices banks in redemption cities. Reserve requirements were seen as necessary for The first commercial banks in this country were ensuring the liquidity of national bank notes and chartered by the states and were not required to thereby reinforcing their acceptability as a medium keep reserves either against deposits, which were of exchange throughout the country. Concentrating little used at the time, or against their own, more reserves in areas where demands for liquidity were ubiquitous, bank notes. In the absence of a national likely to be most acute was thought to be the surest currency, bank notes were commonly used as a means of promoting the widespread use and accep- medium of exchange, though high transaction costs tance of national bank notes. At the same time, of redeeming the notes and limited information allowing banks outside redemption cities to earn about the underlying solvency of the issuer gener- interest on a portion of their reserves made the ally confined the use of any individual bank’s notes burden of reserve requirements less onerous for to a small geographic area. To facilitate the more banks that faced more limited demands for widespread use of their notes, banks in New York liquidity.
  5. 5. Reserve Requirements: History, Current Practice, and Potential Reform 573 The federal government had a keen interest in effect on the economy, the banking system as a seeing the use of national bank notes flourish whole could not without selling securities or call- because, in addition to reserve requirements, ing in loans, thereby squeezing credit supplies, national bank notes were also required to be driving up interest rates, and precipitating a general backed by holdings of government bonds, which financial crisis. were needed to finance the Civil War. To make the issuance of national bank notes less costly, reserve requirements against these notes were lowered for Creation of the Federal Reserve System banks outside redemption cities from 25 percent to 15 percent in 1864, and banks in redemption cities The Federal Reserve Act of 1913 created a system outside New York City were allowed to meet half of Reserve Banks that could act as lenders of last of their requirements with interest-bearing balances resort by accommodating the temporary liquidity at a bank in New York. Still dissatisfied with the needs of the banking system and thereby alleviat- rate of growth of national bank notes, the Congress ing the periodic financial disruptions that plagued imposed a tax on state bank notes in 1865, effec- the national bank era. By discounting eligible assets tively guaranteeing the primacy of national bank of member banks, Federal Reserve Banks provided notes as a medium of exchange. Indeed, in subse- a ready, accessible source of liquidity that had been quent years, these notes began to circulate widely missing from the national banking system. throughout the country and were rarely redeemed. Although the creation of the Federal Reserve With their convertibility no longer in question, System seemingly eliminated any remaining liquid- reserve requirements against national bank notes ity rationale for reserve requirements, banks that were lifted in 1873. Requirements remained in were members of the System were still required to place on deposits, however, which were just emerg- hold reserves, though requirements were lower than ing as an accepted means of payment. As time those previously in effect for most national banks. wore on, the role of deposits expanded, and they In the original Federal Reserve Act, banks had eventually supplanted bank notes as the preferred to hold in reserve different percentages of their medium of exchange for many transactions, with demand deposits—deposits that could be with- their convertibility supposedly reinforced by drawn on demand—depending on whether they reserve requirements. were classified as central reserve city banks A series of bank runs and financial panics in the (18 percent), reserve city banks (15 percent), or late nineteenth and early twentieth centuries made country banks (12 percent).5 In addition, all mem- it patently clear that reserve requirements could ber banks faced a 5 percent requirement on time not really guarantee the convertibility of deposits deposits.6 Member banks outside central reserve for the entire banking system. In fact, reserve cities were not allowed, however, to meet part of requirements were really no help at all in providing their requirements with interest-bearing balances at liquidity during a panic because a given dollar of a bank in a central reserve city. Starting in 1917, reserves could not be used simultaneously to meet moreover, member banks could no longer use vault a customer’s demand for cash and to satisfy reserve cash to satisfy reserve requirements: They had to requirements. What was lacking from the national banking system or, for that matter, from any frac- tional reserve system—one with reserve require- ments of less than 100 percent—was a mechanism 5. Originally, the rationale for these distinctions among cities for accommodating temporary variations in the was a carryover from the designation of redemption cities in the public’s demand for liquidity by adjusting the national bank era. In 1913, banks in New York, Chicago, and quantity of reserves available to the entire banking St. Louis were classified as central reserve city banks, and banks in about fifty other cities were designated as reserve city banks. In system. Absent such a mechanism, systemic panics 1922, St. Louis was reclassified as a reserve city, and in 1962 the and crises stemming from fluctuating liquidity central reserve city designation was eliminated altogether. Over the needs were all too common. Though an individual years, the number of reserve cities changed somewhat as some cities were added and others deleted by the Federal Reserve Board. bank might be able to meet a temporary surge in 6. For details on the history of changes in reserve requirements the demand for cash with little attendant adverse since the inception of the Federal Reserve, see the appendix.
  6. 6. 574 Federal Reserve Bulletin June 1993 meet their requirements entirely with non-interest- In practice, however, reserve requirements were bearing balances at a Federal Reserve Bank. of little help in containing the rapid credit growth On net, therefore, the effective burden of reserve that occurred in the late 1920s. During this period, requirements in terms of forgone interest was the primary tool used by the Federal Reserve to somewhat higher for member banks than for non- influence credit conditions was the discount rate. member banks, particularly for those outside cen- Because this rate was generally kept below market tral reserve cities. To help offset this increased rates and only marginal administrative pressure burden, in 1917 reserve requirements on demand was used to dissuade banks from availing them- deposits were pared further, to 13 percent, 10 per- selves of the discount window, banks had an incen- cent, and 7 percent respectively for the three types tive to borrow the reserves they needed to finance of member banks, and requirements on time depos- their rapidly expanding assets from the Federal its were reduced from 5 percent to 3 percent for all Reserve, and they responded vigorously to this members. These reductions, coupled with the bene- incentive. Throughout much of the 1920s, discount fits of access to Federal Reserve credit at the dis- window borrowings were more than half of total count window and free Federal Reserve services— Federal Reserve assets. With the Federal Reserve such as check clearing and currency distribution— effectively accommodating much of the increased were considered sufficient encouragement for credit expansion, reserve requirements placed no banks to become members of the System, despite significant constraint on lending. In addition, the the higher reserve requirement burden that such Federal Reserve had no authority to raise reserve membership often entailed. In later years, however, requirements even if it had wanted to make them a the burden of reserve requirements would become more binding constraint on credit expansion. more acute, making membership less desirable for During the Great Depression, as market interest many institutions. rates plunged and loan demand all but dried up, reserve requirements were obviously not needed to curtail credit growth. In fact, through much of this Reserve Requirements as a Means of period, banks held large quantities of reserves in Influencing Credit Conditions excess of their reserve requirements, suggesting that reserve requirements were not in any way In the 1920s and 1930s, the Federal Reserve gradu- constraining credit expansion. The Federal Reserve ally began to expand its original, reactive role as was concerned that these large excess reserves lender of last resort and guarantor of the liquidity could eventually be used to support an overly rapid of the banking system and adopted a more proac- buildup of deposits and loans that could ultimately tive posture in attempting to influence the nation’s prove inflationary. Therefore, it excercised its credit conditions. As the emphasis of monetary newly acquired powers under the Banking Act of policy evolved, so too did the rationale for reserve 1935 and doubled the required reserve ratios on requirements. In fact, by 1931, the Federal Reserve both demand and time deposits, thereby effectively had officially abandoned the view that reserves absorbing much of extant excess reserves.8 By were a necessary or useful source of liquidity for 1938, however, as evidence mounted that the deposits, arguing instead that reserve requirements nascent economic recovery was imperiled, the Fed- provided a means for influencing the expansion of eral Reserve moved to trim reserve requirements bank credit.7 Specifically, the Federal Reserve on both demand and time deposits, hoping to free believed that requiring banks to hold reserves up additional funds for lending. against the additional deposits needed to fund each increment of new loans could help restrain an overly rapid expansion of credit. 8. The Thomas Amendment of 1933 first granted authority to the Federal Reserve Board to raise reserve requirements, subject to presidential approval, provided that a national emergency was 7. See ‘‘Member Bank Reserves—Report of the Committee on declared. The Banking Act of 1935 eliminated the need for presi- Bank Reserves of the Federal Reserve System,’’ in Board of Gover- dential approval or the declaration of an emergency, though it also nors of the Federal Reserve System, 19th Annual Report, 1932 precluded the Board from reducing requirements below the levels (Board of Governors, 1933), pp. 260–85. then in force or from more than doubling those requirements.
  7. 7. Reserve Requirements: History, Current Practice, and Potential Reform 575 In the years surrounding World War II, monetary Reserve requirements were also imposed on policy considerations became subordinate to other, newly emerging liabilities that were the func- financing the government debt. During this period, tional equivalents of deposits. For example, as the Federal Reserve abandoned an active monetary banks started to rely more on Eurodollar borrow- policy role and chose as its highest priority to ings as a funding source in the late 1960s, partly in accommodate the government’s financing needs by an effort to circumvent existing reserve require- buying Treasury securities at low interest rates. ments, the Federal Reserve imposed marginal requirements on these liabilities and adjusted these Postwar Issues: Membership Attrition and requirements periodically throughout the 1970s. Monetary Control The imposition of reserve requirements on these and other managed liabilities was especially useful In 1951, the Federal Reserve resumed an active, in the late 1970s, as the Federal Reserve aggres- independent monetary policy. In subsequent years, sively sought to curb the expansion of money and reserve requirements were adjusted numerous credit and thereby ease price pressures. times, usually to reinforce or supplement the effects Throughout this period, reserve requirements of open market operations and discount policy also had important implications for membership in on overall monetary and credit conditions. In the the Federal Reserve System. Since membership short run, however, reserve requirements placed was optional for state-chartered banks, some of little constraint on the expansion of deposits these institutions began to leave the System in the because the Federal Reserve largely accom- 1950s to take advantage of the lower reserve modated any such expansion through open market requirements imposed by most state regulatory operations. Over time, though, if the Federal authorities, some of whom also allowed banks to Reserve sought to reduce the availability of money meet part of their requirements with interest- and credit by providing reserves less generously earning assets. The Federal Reserve feared that if through open market operations, it could and enough banks left the System, changes in the cost often did augment its actions by raising reserve and availability of reserves to the remaining mem- requirements. ber banks might have a diminished effect on over- The use of reserve requirements as a supplemen- all monetary and credit conditions, thus undermin- tal tool of monetary policy was particularly preva- ing the efficacy of monetary policy. lent in the 1960s and 1970s, as the Federal Reserve sought to influence the expansion of money and Change in vault cash accounting. To reduce the credit in part by manipulating bank funding costs. burden of reserve requirements and stem the ero- As financial innovation spawned new sources of sion of membership in the System, legislation was bank funding, the Federal Reserve began to adapt enacted allowing banks to resume using vault cash reserve requirements to these new financial prod- to satisfy their reserve requirements. This change, ucts and often changed requirements on the specific which was phased in beginning December 1959, bank liabilities that were most frequently used provided the greatest relief to small banks, which as marginal sources of funding. As banks began tended to hold relatively large quantities of vault to rely more heavily on the issuance of large- cash to meet their customers’ liquidity needs. Per- denomination time deposits (CDs) to fund their mitting this vault cash to be used to meet reserve asset acquisitions in the 1960s, for example, the requirements reduced the amount of non-interest- Federal Reserve began periodically to alter reserve bearing balances these banks had to hold at the requirements on these instruments, thereby affect- Federal Reserve. Because smaller banks were most ing their cost of issuance and, thus, the supply of apt to leave the System, it was hoped that this credit through banks. It sometimes supplemented reform would help stanch membership attrition. its actions by placing a marginal reserve require- Although larger banks tended to benefit less from ment on large time deposits—that is, an additional this rule change, they were less likely to leave the requirement applied only to each new increment of System because they often reaped the greatest these deposits. benefits from free Federal Reserve services, par-
  8. 8. 576 Federal Reserve Bulletin June 1993 1. Burden of reserve requirements, 1959–92¹ 2. Marginal reserve tax on transaction deposits, 1959–93:Q1¹ Billions of dollars Basis points 60 25 Applied Required reserves vault cash 20 40 15 20 10 Required reserve balances 5 Percentage points 1960 1965 1970 1975 1980 1985 1990 1. The marginal reserve tax is the quarterly average effective federal 15 funds rate times the highest reserve requirement on transaction deposits Effective federal funds rate during the quarter. 10 5 became more onerous; with higher interest rates, banks were being forced to forgo more earnings by holding non-interest-bearing required reserve bal- Billions of dollars ances. Indeed, the marginal tax rate on transaction (demand) deposits—the reserve tax on an addi- Forgone interest tional dollar of these deposits, as measured by the (1982 dollars)2 6 reserve requirement times the rate of interest 4 forgone—rose through much of this period as well (chart 2). As a result, more banks began to leave 2 the Federal Reserve System, taking with them an Forgone interest ever-increasing share of the deposits in the banking (Actual dollars)2 system. By the early 1970s, for example, the share 1960 1965 1970 1975 1980 1985 1990 of transaction deposits held by member banks had 1. Data are annual averages. fallen below 75 percent from nearly 85 percent in 2. Forgone interest is defined as required reserve balances multiplied by the late 1950s (chart 3). In response, the Federal the federal funds rate. Reserve began to argue for additional legislation aimed at stemming the corrosive effects of the decline in membership on monetary control. Either ticularly those related to the clearing of financial all depository institutions should be subject to transactions. reserve requirements established by the Federal The change in vault cash accounting did in fact Reserve, thereby rendering the membership issue reduce the level of required reserve balances some- irrelevant, the System argued, or interest should be what in the early 1960s (top panel of chart 1). This paid on required reserve balances, thereby remov- decline, coupled with a drop in short-term interest ing banks’ primary motive for leaving the System.9 rates (middle panel of chart 1), helped lighten the Opposition to both proposals proved strong, burden of reserve requirements in terms of the however, with nonmember banks leading the cru- interest forgone on required reserve balances (bot- sade against universal reserve requirements and tom panel of chart 1). Proposals to change the structure of reserve requirements. This relief proved temporary, how- 9. Each Annual Report of the Board of Governors of the Federal Reserve System between the years 1964 and 1979 argued for the ever. As interest rates climbed in the late 1960s and adoption of legislation aimed at reforming the structure of reserve into the 1970s, the burden of reserve requirements requirements to combat the problem of membership attrition.
  9. 9. Reserve Requirements: History, Current Practice, and Potential Reform 577 3. Member bank transaction deposits as a share of total reserve positions. One problem with LRR was that transaction deposits, 1959–80¹ it weakened the direct, contemporaneous link Percent between reserves and money, thus making it harder, in principle, to manipulate reserves to control 85 money, at least in the short run. This problem was not considered a serious one, however, because 80 Federal Reserve procedures at that time were not 75 directed at tight, short-run control of money 70 through a reserves operating target. 65 Graduated reserve requirements. In the late 1960s, the Federal Reserve also began to move 1960 1965 1970 1975 1980 away from a system of reserve requirements based 1. Transaction deposits are defined as net demand deposits plus NOW on geographic distinctions, as embodied in the accounts. Data are expressed as annual averages. reserve city bank and country bank designations. with both the legislative and executive branches of By 1972, the old system was eliminated altogether, the federal government opposed to interest on and a new system with a progressive, graduated reserves out of concern about Treasury revenues. reserve requirement schedule was implemented. In fact, a 1963 presidential commission cautioned Under the new system, reserve requirements against any significant cuts in reserve requirements increased with the level of each bank’s deposits, to avoid a sharp drop in Treasury revenue.10 Most independent of its location. Although the specifics academics, by contrast, usually supported retaining were somewhat complicated (see the appendix for and even increasing reserve requirements to tighten details), the upshot of the change was to reduce the link between reserves and money, while paying reserve requirements for smaller banks, which were interest on reserves to eliminate the distortional still most likely to leave the System. At the same effects of the reserve tax.11 time, however, the move to a system with many reserve requirements based on different deposit Lagged reserve requirements. Thwarted in its levels further weakened the link between the aggre- attempts to promote substantive change in the gate level of reserves and the total amount of structure of reserve requirements, the Federal deposits in the banking system. Again, however, Reserve took several smaller, unilateral steps aimed because the Federal Reserve was not trying to at stemming membership attrition. In 1968, a sys- maintain control of deposits through a reserves- tem of lagged reserve requirements (LRR) was targeting procedure, this effect was not a major implemented in which a bank’s required reserves concern. were computed based on its deposit levels from two weeks earlier. Previously, the computation Continued decline of membership. Despite the period for deposits had been essentially contempo- efforts of the Federal Reserve, the decline of mem- raneous with the maintenance period for reserves. bership in the System continued unabated, with the By switching to LRR, the Federal Reserve hoped to proportion of transaction deposits at member banks make it less difficult and costly for banks to calcu- falling below 65 percent of total transaction depos- late their reserve requirements and to manage their its by the late 1970s (chart 3), in part because rising interest rates were enlarging the reserve tax 10. Report of the Committee on Financial Institutions to the (charts 1 and 2). In response, the Federal Reserve President of the United States, Walter W. Heller, Chairman began to argue more vociferously for changes in (GPO, 1963). the structure of reserve requirements to prevent 11. See, for example, Milton Friedman, A Program for Monetary Stability (Fordham University Press, 1959), membership attrition from further undermining the pp. 65–76; Thomas Mayer, ‘‘Interest Payments on Required efficacy of monetary policy.12 In 1978, it even went Reserve Balances,’’ Journal of Finance, vol. 21 (March 1966), pp. 116–18; and George S. Tolley, ‘‘Providing for Growth of the Money Supply,’’ Journal of Political Economy, vol. 65 (December 12. See ‘‘Statement by G. William Miller, Chairman, Board of 1957), pp. 477–85. Governors of the Federal Reserve System, before the Committee
  10. 10. 578 Federal Reserve Bulletin June 1993 so far as to propose a unilateral plan to pay interest also granted the Federal Reserve authority to on reserves, which elicited strenuous congressional impose a supplemental reserve requirement of up opposition.13 to 4 percent on transaction accounts. Finally, as a The relative decline in the deposit base at mem- result of MCA, the number of depositories required ber banks became particularly worrisome after to report their deposits to the Federal Reserve October 1979, when the Federal Reserve adopted a increased markedly, thus improving the accuracy reserves-based operating procedure designed to and timeliness of data necessary for monetary maintain close, short-run control of Ml. The suc- control. cess of this procedure depended in part on how To ease the burden of reserve requirements, the tight the link was between reserves at member MCA initially set the basic reserve requirement on banks and the level of M1 deposits in the entire transaction deposits at 12 percent—below the banking system—a link that was being weakened 161⁄4 percent maximum that had been in effect by the continued decline in membership as well for member banks—and prohibited the Federal as by some of the steps the Federal Reserve had Reserve from raising this requirement above taken to try to reverse this decline, including 14 percent. It also set a 3 percent reserve require- switching to LRR and instituting graduated reserve ment on the first $25 million of deposits at each requirements. institution—the so-called low reserve tranche—as a special concession to smaller depositories. In 1982, the Garn–St Germain Act went even The Monetary Control Act and M1 Targeting further by exempting from reserve requirements altogether the first $2 million of deposits. The law After years of debate, the Congress finally adopted mandated annual adjustments to the cutoffs for the legislation to reform reserve requirement rules in exemption and the low reserve tranche based on order to end the problem of membership attrition aggregate growth in reservable liabilities and trans- and facilitate control of Ml. The Monetary Control action deposits respectively. To help smooth the Act of 1980 (MCA) mandated universal reserve transition for nonmember banks and thrift institu- requirements to be set by the Federal Reserve for tions, a multiyear phase-in period was put in place, all depository institutions, regardless of their mem- and the Federal Reserve was also prohibited from bership status. The act also vastly simplified the putting reserve requirements on personal time and graduated reserve requirement schedule, further savings deposits, which were particularly impor- tightening the link between reserves and money. tant sources of funds for these institutions. Finally, Although the key focus was on transaction (M1) all institutions with reservable deposits, not just deposits, all of which were made subject to reserve member banks, now had access to the discount requirements, certain types of nontransaction window as well as to Federal Reserve services, deposits also became subject to requirements, including check clearing, funds transfers, and the which effectively broadened the reserve base and like, though these services were no longer to be required more depositories to hold reserve bal- provided free of charge. ances. In this way, the Federal Reserve’s ability to The MCA did not specifically prohibit or autho- influence aggregate deposit levels by manipulating rize the payment of interest on required reserves, the quantity of reserves was improved. The MCA although it mandated the payment of interest on supplemental reserves should the Federal Reserve ever impose them. The legislative history of the on Banking, Finance and Urban Affairs, U.S. House of Representa- tives, July 27, 1978,’’ Federal Reserve Bulletin, vol. 64 (August MCA indicates that the Congress was concerned 1978), pp. 636–42; and ‘‘Statement by Paul A. Volcker, Chairman, about the possible adverse effects of the act on Board of Governors of the Federal Reserve System, before the Treasury revenues, so much so that the MCA even Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 4, 1980,’’ Federal Reserve Bulletin, vol. 66 (February prohibits the Federal Reserve from lowering the 1980), pp. 643–48. reserve requirement to less than 8 percent on trans- 13. For details on the Federal Reserve’s proposal, see Federal action deposits. The legislative history also indi- Reserve Bulletin, vol. 64 (July 1978), pp. 605–10. For congres- sional reaction, see ‘‘Monetary Control and the Membership cates that the Congress was concerned that pay- Problem.’’ Hearings. ment of interest on reserves would give the Federal
  11. 11. Reserve Requirements: History, Current Practice, and Potential Reform 579 Reserve, in its role as a provider of financial ser- facilitate the control of M1 through a reserves- vices, an unfair competitive advantage over deposi- oriented targeting procedure, had seemingly tory institutions, which are prohibited from paying become an anachronism. interest on demand deposits. Appreciative of this In fact, however, reserve requirements continued concern and aware of the distortions created by the to play an important role in the conduct of mone- prohibition of interest payments on demand depos- tary policy, in part by providing a stable, predict- its, the Federal Reserve advocated removal of this able demand for aggregate reserves. Absent reserve prohibition in conjunction with the payment of in- requirements, banks would still hold some balances terest on reserves.14 Neither proposal was adopted, at the Federal Reserve to meet their clearing needs. however. Thus, the reserve tax on depositories and Given the size and volatility of the financial trans- their customers remained. actions that clear through these reserve accounts, In 1982, the Federal Reserve took another step to depositories need to maintain a cushion of balances improve its short-run control of M1 by deciding to in these accounts to provide some protection switch to a contemporaneous reserve requirement against uncertain debits that can potentially leave (CRR) scheme. By making the period in which their accounts overdrawn at the end of the day and banks are required to maintain their reserves subject to stiff penalties.16 The exact amount of against transaction deposits virtually contempora- balances that banks wish to hold for clearing pur- neous with the period in which deposit levels are poses may vary considerably from day to day, computed for the purpose of determining reserve however, and cannot be forecast with much preci- requirements, this move tightened the real-time sion by the Federal Reserve. By making reserve link between reserves and M1.15 In so doing, it requirements the binding constraint on banks’ remedied a weakness in the short-run monetary demand for reserves—that is, by keeping required control mechanism of the existing, reserves-based reserve balances above the uncertain level needed operating procedure. for clearing purposes—the Federal Reserve can more accurately determine the banking system’s demand for reserves. In this way, it can more Reserve Requirements since the Abandonment readily achieve any desired degree of pressure on of MI Targeting bank reserve positions and associated reserve market conditions simply by manipulating the Ironically, by the time CRR was instituted in 1984, maintenance-period-average supply of reserves. the Federal Reserve had shifted its focus away By requiring banks to hold an average amount of from short-run control of M1 via a reserves-based reserves over a two-week maintenance period operating procedure, preferring instead to influence rather than a specific amount on each day, current monetary and credit conditions by adjusting the regulations allow considerable flexibility in daily cost and availability of reserves to depositories. It reserve management. Banks can use this flexibility also shifted its focus more toward M2, as this to arbitrage anticipated, intraperiod variations in aggregate was seen as more closely linked to the the cost of reserves (the federal funds rate), by ultimate objectives of monetary policy than M1, substituting reserves on one day of the period when which had become overly sensitive to interest rates they are expected to be less costly for reserves on after the authorization of nationwide NOW another day when they are expected to be more accounts and the general deregulation of deposit costly. This sort of intraperiod arbitrage serves to rates. Thus, the basic structure of reserve require- reduce day-to-day fluctuations in the cost of ments, which had been meticulously designed to reserves. The lower the level of required reserve balances, however, the less leeway a bank has for manipulating the intraperiod profile of its reserve 14. See statement by J. Charles Partee, October 27, 1983. 15. Actually, banks were required to hold an average amount of reserves over a two-week maintenance period ending every other 16. At present, the penalty rate on overnight overdrafts is the Wednesday, based on average deposit levels in a two-week compu- higher of 200 basis points above the federal funds rate on the day, tation period that ends on a Monday two days before the end of the or 10 percent. In addition, banks have to offset overdrafts later in maintenance period. the period to meet their reserve requirements.
  12. 12. 580 Federal Reserve Bulletin June 1993 4. Reserve and clearing balances, 1980–89 5. Volume of funds transactions clearing through reserve accounts, 1980–90 Billions of dollars Billions of dollars 35 Required reserve balances 800 30 600 25 400 20 200 1980 1982 1984 1986 1988 1990 Billions of dollars 1980 1982 1984 1986 1988 1990 Observations are annual averages of daily data. 1.8 Required clearing balances 1.5 1.2 maintenance period and hence to provide extra .9 insurance against overdrafts and added flexibility Excess reserves .6 to reserve management. .3 Not surprisingly, in the years immediately after passage of MCA, as required reserve balances fell 1980 1982 1984 1986 1988 as a result of the phased reductions in reserve Data are annual averages. requirements for member banks (top panel of chart 4), many of these institutions opened clearing balances to help replenish their diminished protec- position without jeopardizing its overnight over- tion against overdrafts. Indeed, by 1986, the bank- draft protection; hence, the bank will be less able to ing system as a whole had contracted to hold arbitrage day-to-day variations in the federal funds roughly $13⁄4 billion of clearing balances (bottom rate. panel of chart 4). To a lesser extent, other banks, Banks that find their required reserve balances particularly those using small amounts of priced insufficient to meet their clearing needs—that is, to services from the Federal Reserve and those new to provide them with adequate overdraft protection— managing reserve accounts, increased their hold- are able, under the provisions of MCA, to open ings of excess reserves to help meet their clearing clearing balances. Banks can contract with the Fed- needs. These changes, coupled with a rebound in eral Reserve to hold an average amount of these required reserve balances, provided banks with balances in their reserve accounts over the two- more of a cushion to handle a sharp increase in the week reserve maintenance period. If they fail to volume of funds transactions clearing through their hold the amount required under the contract, they reserve accounts (chart 5). are penalized, much as would be the case if they failed to hold sufficient balances to meet their reserve requirements. Unlike required reserve bal- RECENT CUTS IN RESERVE REQUIREMENTS ances, however, which do not earn interest, banks receive earnings credits on the amount of clearing In the decade after passage of the MCA in 1980, balances they are required to hold under their con- the Federal Reserve left reserve requirements tractual agreement. They can, in turn, use these essentially unchanged. More recently, however, it earnings credits to defray the costs of Federal has taken two steps to reduce these requirements. Reserve priced services. Thus, from a bank’s per- In December 1990, the required reserve ratio on spective, opening a clearing balance is a virtually nontransaction accounts—nonpersonal time and costless way to boost the average balance it is savings deposits and net Eurocurrency liabilities— required to hold in its reserve account over the was pared from 3 percent to zero, and in April
  13. 13. Reserve Requirements: History, Current Practice, and Potential Reform 581 1992, the 12 percent requirement on transaction 2. Effect of recent cuts in reserve requirements deposits was trimmed to 10 percent. Reduction in Reduction in Federal Effective required reserve interest funds date of balances forgone rate cut (billions of (millions of (percent) dollars) dollars) Rationale December 1990 . . . . . . 111⁄2 7.0 800 April 1992 . . . . . . . . . . 8 1⁄ 2 4.0 350 These actions were motivated in part by develop- ments in credit markets, where evidence had emerged suggesting that some lenders had adopted a more cautious approach to extending credit. This Using the 7 percent federal funds rate that pre- caution was exerting a restraining effect on the cost vailed at the time as a proxy for the interest that and availability of credit to some types of borrow- could have been earned on these balances, the cut ers. By reducing depository funding costs and thus in reserve requirements translated into an increase providing depositories with easier access to capital of about $800 million in the annual, pretax earn- markets, the cuts in reserve requirements were ings of depositories and their customers. designed to put banks in a better position to extend As a result of this cut in reserve requirements, credit. In particular, the cut in the requirement on about 2,500 depositories whose vault cash had nonpersonal time deposits was aimed directly at formerly been insufficient to meet their reserve spurring bank lending because these accounts are requirements were no longer bound to hold bal- often used as a marginal funding source. Of course, ances at the Federal Reserve. For these institutions, it was recognized that some, if not all, of the therefore, the reduction in the nontransaction benefits stemming from the reserve requirement requirement essentially eliminated the reserve tax. cuts would likely be passed on, over time, to bor- Trimming the required reserve ratio on transaction rowers and lenders.17 accounts in April 1992 relieved several hundred The cuts in reserve requirements were also moti- additional institutions from having to hold balances vated by the Federal Reserve’s recognition that at the Federal Reserve. Overall, this second cut in much of the early-1980s rationale for reserve reserve requirements reduced the required reserve requirements had evaporated with the abandon- balances of the entire banking system about ment of a reserves-oriented operating procedure $81⁄2 billion, resulting in annual pretax savings of geared to short-run control of M1. At the same roughly $350 million for the private sector, given time, it realized that reserve requirements still the 4 percent federal funds rate that prevailed at the played a vital role in policy implementation. time. Indeed, it chose not to make even deeper cuts in requirements for fear that required balances would fall to levels insufficient to satisfy the normal clear- Effects on Bank Reserve Management ing needs of the banking system. and Open Market Operations In the immediate aftermath of the December 1990 Effects of Reserve Requirement Cuts on the cut in reserve requirements, the level of required Size of the Reserve Tax operating balances—the sum of required reserve balances and the amount of clearing balances re- The elimination of the 3 percent reserve require- quired to be held under contractual arrangements ment on nontransaction accounts at the end of 1990 between depositories and the Federal Reserve— reduced the level of required reserve balances plunged (chart 6). By early February 1991, these roughly $111⁄2 billion, or about one-third (table 2). balances reached a trough of about $181⁄4 billion— barely more than half their level in the period preceding the cut in requirements and nearly 17. For details on the rationales for the recent cuts in reserve 40 percent below their seasonal low in early Febru- requirements, see Federal Reserve Bulletin, vol. 77 (February 1991), pp. 95–96; and Federal Reserve Bulletin, vol. 78 (April ary 1990. Required operating balances typically 1992), pp. 272–73. reach a low point at this time of the year because
  14. 14. 582 Federal Reserve Bulletin June 1993 6. Reserve balances, 1989–March 31, 1993 With required operating balances falling below Billions of dollars the levels needed by many depositories for daily clearing purposes, the marginal dollar of reserve 1 Maintenance period averages 45 demand often stemmed from clearing needs on the Reserve Reserve requirement cut requirement cut 40 day, rather than from a reserve requirement aver- Required 35 aged over two weeks. As a result, banks had less operating scope for manipulating their reserve positions from balances2 30 one day to the next and, consequently, for arbitrag- 25 ing anticipated intraperiod variations in the cost of Required 20 reserves. Not surprisingly, a variety of measures of reserve balances federal funds rate volatility posted significant 1989 1990 1991 1992 1993 increases (chart 7). At the same time, many deposi- 1. Reserve maintenance periods run for two weeks, so that there are tories held levels of excess reserves that greatly twenty-six periods each year. In this chart and in charts 7, 8 ,and 9, there are twenty-six observations for each full year. exceeded those seen in comparable periods of 2. Required operating balances are required reserve balances plus recent years in order to restock their depleted over- required clearing balances. draft protection (chart 8). Because the extent to which banks wanted to boost their holdings of excess reserves was unknown to the Federal required reserves fall from their end-of-year peak. Reserve, it became more difficult to estimate the Also, owing to regulations stipulating that deposi- demand for reserves and, thus, to conduct open tories apply their vault cash holdings from two market operations. maintenance periods earlier in meeting their cur- rent reserve requirements, the enlarged holdings of vault cash from year-end do not become available for use in meeting reserve requirements until late Transition to a More Orderly Reserve Market January and early February. Over the next few months, reserve market condi- tions returned to normal, with both excess reserves 7. Reserve market volatility, 1988–March 31, 1993 and the volatility of the funds rate falling back more or less to levels seen before the cut in reserve Percent (ratio scale) requirements. Although the reasons for the more 1 Variance of daily effective federal funds rate stable reserve market climate varied, the rapid Reserve Reserve 30 rebuilding of required operating balances was prob- requirement cut requirement cut 10 ably the most important. The higher level of bal- 1 ances provided banks with more adequate overdraft protection and greater flexibility in managing their reserve positions, thus reducing the need for excess 8. Excess reserves, 1989–March 31, 1993 Basis points Billions of dollars Mean absolute deviation of daily effective federal 120 funds rate from the maintenance period average Maintenance period averages Reserve Reserve 100 Reserve Reserve 5 requirement cut requirement cut requirement cut requirement cut 80 4 60 3 40 2 20 1 1988 1989 1990 1991 1992 1993 1989 1990 1991 1992 1993 1. Computed around the maintenance period average.
  15. 15. Reserve Requirements: History, Current Practice, and Potential Reform 583 9. Required clearing balances, 1989–March 31, 1993 balances quickly made up all their lost ground, Billions of dollars spurred by continued rapid growth in required reserves and another surge in the use of clearing Maintenance period averages balances. Indeed, these balances now total about 8 Reserve Reserve $6 billion, or more than three times their level requirement cut requirement cut 6 before the first cut in reserve requirements; they now make up nearly 20 percent of required operat- 4 ing balances versus about 5 percent in late 1990. The Federal Reserve also made several changes 2 in reserve accounting rules to help banks better manage their accounts in a world of lower require- 1989 1990 1991 1992 1993 ments and to aid the implementation of monetary policy. First, to smooth the seasonal pattern in balances and providing additional leeway for arbi- required operating balances, the Federal Reserve trage in the funds market. reduced the lag on the application of vault cash for The pronounced rebound in required operating use in meeting reserve requirements from two balances over the remainder of 1991 owed in part maintenance periods to one, effective in the period to a surge in required reserves stemming from beginning November 12, 1992. By more closely rapid growth in transaction deposits. Furthermore, synchronizing the movements in required reserves deliberate efforts by depositories to hold additional and applied vault cash, this change was designed to balances also played a role in the faster-than-usual temper seasonal declines in required operating bal- increase in required operating balances. For exam- ances, particularly the most severe decline, which ple, banks used clearing balances much more after occurs in late January and early February. To give the cut in reserve requirements (chart 9). Evidence depositories greater flexibility in managing their also suggests that some banks sought to economize reserve positions from one period to the next, the on their vault cash holdings to boost their required Federal Reserve also doubled the carryover privi- reserve balances. In addition, depositories may lege, which enables banks to carry forward into the have learned to manage their reserve accounts more next maintenance period small reserve surpluses efficiently, making use of improved, real-time and deficiencies.18 information on the status of their reserve balances These changes, coupled with the rebound in throughout the day to lower the cushion they required operating balances, helped prevent the cut needed to hold as insurance against uncertain debits in the transaction requirement from having adverse that can result in overdrafts. effects on the functioning of the reserve market or on the conduct of open market operations. In fact, most measures of the volatility of the federal funds The Cut in the Transaction Requirement rate are up only marginally relative to their levels before December 1990, and aggregate excess With the reserve market functioning reasonably reserves are running only a shade higher than well again, the Federal Reserve believed that it before the cuts in reserve requirements. Some evi- could safely lower reserve requirements once more. dence suggests, however, that banks do have a bit As it turned out, the cut in the transaction require- less flexibility in managing their reserve positions ment in April 1992 was relatively uneventful. from day to day; in particular, some systematic Although required operating balances initially patterns in the behavior of the federal funds rate dropped sharply, the decline was not nearly as within reserve maintenance periods have intensi- precipitous as that seen in early 1991; not only was fied, suggesting that banks may not have as much this cut smaller in terms of its effect on required reserve balances, it also came at a time of the year when these balances tend to be high because of the 18. Since September 1992, depositories have been able to carry forward one maintenance period the greater of 4 percent of required buildup of transaction deposits in anticipation of reserve plus clearing balances, or $50,000; the carryover allowance the April 15 tax date. Moreover, required operating had previously been the greater of 2 percent, or $25,000.
  16. 16. 584 Federal Reserve Bulletin June 1993 scope to arbitrage in the funds market as they once reserves-oriented targeting procedure to control did.19 money growth if it ever deemed this action Concerned that additional declines in required appropriate. operating balances would complicate reserve man- agement and the conduct of open market opera- Recent Trends in Other Countries tions, the Federal Reserve has not made further cuts in reserve requirements. Nevertheless, owing Several other countries have significantly reduced, to the cuts it did make as well as to declines in and in some cases essentially eliminated, reserve short-term interest rates, the reserve tax has been requirements in recent years. In the United King- falling sharply in recent years (chart 1). Conse- dom and Switzerland, for example, reserve require- quently, the marginal tax rate on transaction depos- ments no longer effectively constrain bank behav- its has dipped to its lowest level in thirty years ior. In these countries, most banks find that their (chart 2). Even so, this tax still represents a burden required reserves fall short of their daily clearing on the private sector, and one that could rise signifi- needs, so that at the margin the latter essentially cantly if interest rates were to increase. Cognizant determine their demand for reserves. More recently, of the actual and prospective burden of the reserve Canada has also begun to phase out reserve tax, depositories continue to work to fashion finan- requirements, and by 1994, their requirements will cial products aimed largely at exploiting loopholes be completely eliminated. in reserve regulations. These countries have taken different steps, based on their own unique institutional structures, to facilitate bank reserve management and the con- POTENTIAL REFORMS TO THE duct of open market operations in a world of non- CURRENT SYSTEM binding reserve requirements. The Bank of England (BOE), for example, has adopted a more flexible Several suggestions have been put forth over the operating procedure, often intervening in the years for reforming the system of reserve require- money markets several times a day to fine tune the ments. In this section, I review some of these cost and availability of reserves to meet ever- proposals, drawing heavily on the lessons learned changing clearing needs. In addition, banks in the from the recent cuts in reserve requirements as well United Kingdom are usually willing to borrow as from the experiences of other countries that have from the BOE late in the day to meet their clearing lowered reserve requirements in recent years. needs. Banks in the United States, by contrast, have become increasingly reluctant in recent years to Eliminate Reserve Requirements avail themselves of Federal Reserve discount win- dow credit, in part out of concerns that doing so Although this proposal would clearly eliminate the might be interpreted by market participants as a reserve tax, recent experience suggests that it sign of financial weakness. Even so, the volatility would also engender a significant increase in vola- of overnight interest rates in the United Kingdom tility in the reserves market and seriously compli- has tended, on average, to be somewhat higher than cate the conduct of open market operations. More- that in the United States, where reserve require- over, absent reserve requirements, the Federal ments are still binding for many institutions. Reserve would be unable to reinstitute an effective, The Swiss National Bank (SNB) has adopted a different approach than the BOE. Although it now 19. Specifically, the federal funds rate has tended to be lower on places somewhat greater emphasis on smoothing Fridays, when reserves count three times in the calculation of a short-term interest rates than it did in the past, it bank’s period-average position; depositories are apparently more has been much less accommodative in offsetting reluctant to build up their reserve balances on these days for fear that they will be unable to work them off later in the period without temporary fluctuations in clearing needs than has jeopardizing their overdraft protection. On settlement days, by the BOE. As a result, Switzerland has experienced contrast, the funds rate has tended to be higher, as banks move greater volatility in overnight rates than the United more aggressively to meet their reserve requirements. The persis- tence of systematic, intraperiod patterns in the funds rate suggests Kingdom, and Swiss banks have chosen to hold that arbitrage opportunities are not being fully exploited. substantial excess reserves, in part because over-