Reserve Requirements: History, Current Practice, and ...

1 Reserve Requirements: History, Current Practice, and Potential ReformJoshua N. Feinman, of the Board s Division ofMonetary Affairs, prepared this article. JanaDeschler and Christoph Hinkelmann providedresearch requiring banks and other depository institu-tions to hold a certain fraction of their deposits inreserve, in very safe, secure assets, have been a partof our nation s banking history for many years. Therationale for these requirements has changed overtime, however, as the country s financial systemhas evolved and as knowledge about how reserverequirements affect this system has grown. Beforethe establishment of the Federal Reserve System, Reserve requirements were thought to help ensurethe liquidity of bank notes and deposits, particu-larly during times of financial strains.

2 As bank runsand financial panics continued periodically toplague the banking system despite the presence ofreserve requirements, it became apparent thatthese requirements really had limited usefulness asa guarantor of liquidity. Since the creation of theFederal Reserve System as a lender of last resort,capable of meeting the liquidity needs of the entirebanking system, the notion of and need for reserverequirements as a source of liquidity has all butvanished. Instead, Reserve requirements haveevolved into a supplemental tool of monetarypolicy, a tool that reinforces the effects of openmarket operations and discount policy on overallmonetary and credit conditions and thereby helpsthe Federal Reserve to achieve its useful as an auxiliary policy tool, reserverequirements also have important implications forthe efficacy of the Federal Reserve s primary tool,open market operations.

3 In the early 1980s, forexample, when open market operations weregeared toward fostering fairly precise, short-runcontrol of narrowly defined money (M1), reserverequirements were designed to help facilitate thiscontrol by establishing a relatively stable, contem-poraneous link between reserves and M1 the Federal Reserve is no longer pursuingthis type of short-run control of money, reserverequirements still play an important role in theconduct of open market operations, which are nowaimed at influencing general monetary and creditconditions by varying the cost and availability ofreserves to the banking system. By helping toensure a stable, predictabledemandfor reserves, Reserve requirements better enable the FederalReserve to achieve desired Reserve market condi-tions by controlling thesupplyof reserves; in sodoing, they help prevent potentially disruptive fluc-tuations in the money requirements are not costless, the contrary, requiring depositories to hold acertain fraction of their deposits in Reserve , eitheras cash in their vaults or as non-interest-bearingbalances at the Federal Reserve , imposes a cost onthe private sector equal to the amount of forgoneinterest on these reserves or at least on the frac-tion of these reserves that banks hold only becauseof legal requirements and not because of the needsof their customers.

4 The higher the level of reserverequirements, the greater the costs imposed on theprivate sector; at the same time, however, higherreserve requirements may smooth the implementa-tion of monetary policy and damp volatility in thereserves Federal Reserve could resolve this policydilemma by paying interest on required reserves, orat least on the part of these reserves that bankswould not hold were it not for legal an explicit, market-based rate of return onthese funds would effectively eliminate much ofthe costs of Reserve requirements without jeopardiz-ing the stable demand for reserves that is neededfor open market operations and for the smoothfunctioning of the reserves Federal Reserve Board has long supportedlegislation that would explicitly allow interest to bepaid on the balances that depositories are requiredto hold in Reserve though not on the cash theyhold in their vaults, which is assumed to be heldprimarily to meet customer needs but to no has typically centered on the adverseimplications such a move would have for Treasuryrevenue.

5 If the Federal Reserve paid interest onrequired balances, its net earnings would decline,and because it turns the vast majority of its earn-ings over to the Treasury, the Treasury s revenueswould decline as well. On the other hand, eliminat-ing the costs of Reserve requirements would removeone government-mandated impediment to deposit-taking and lending through the banking , the costs of depository intermediationhave risen sharply because of higher deposit insur-ance premiums, stiffer capital requirements, morestringent standards for interbank lending, and otherregulatory burdens. Much of these increased costshave likely been passed on to the customers ofdepositories in the forms of higher loan rates andlower deposit rates; paying interest on reserveswould be one way of countering some of thesegovernment-mandated increases in ANDCURRENTRULES OFRESERVEREQUIREMENTSU ndercurrentregulations,alldepositoryinst itutions commercial banks, savings banks,thrift institutions, and credit unions are requiredto maintain reserves against transaction deposits,which include demand deposits, negotiable orderof withdrawal accounts, and other highly against these deposits can take theform either of currency on hand (vault cash) orbalances at the Federal Reserve .

6 The FederalReserve may vary the percentage of transactiondeposits that must be kept in Reserve , but onlywithin fairly narrow limits prescribed by law;requirements may also be imposed on certain typesof nontransaction accounts, though again onlywithin specified present, the requiredreserve ratio on nontransaction accounts is zero,while the requirement on transaction deposits is10 percent, which is near the legal depositories are able to satisfy their entirereserve requirement with vault cash, which theyhold primarily to meet the liquidity needs of theircustomers and would likely hold even in theabsence of Reserve requirements. For these institu-tions, Reserve requirements are essentially 3,000 depositories, however, have vault cashholdings that are insufficient to satisfy their entirereserve requirement.

7 To meet their requirements,these institutions must also maintain deposits,called required Reserve balances, at the Requirements as a TaxSome uncertainty exists as to whether the FederalReserve Act permits interest to be paid on fact, the Federal Reserve has never actually paid1. See, for example, Statement by Arthur F. Bums, Chairman,Board of Governors of the Federal Reserve System, before theSubcommittee on Financial Institutions of the Committee on Bank-ing, Housing, and Urban Affairs, Senate, June 20, 1977, Federal Reserve Bulletin, vol. 63 (July 1977), pp. 636 43; State-ment by J. Charles Partee, member, Board of Governors, before theSubcommittee on Financial Institutions Supervision, Regulationand Insurance of the Committee on Banking, Finance and UrbanAffairs, House of Representatives, October 27, 1983, FederalReserve Bulletin, vol.

8 69 (November 1983), pp. 840 52; and Statement by Alan Greenspan, Chairman, Board of Governors ofthe Federal Reserve System, before the Subcommittee on DomesticMonetary Policy of the Committee on Banking, Finance and UrbanAffairs, House of Representatives, February 19, 1992, Gov-ernment Printing Office, Serial No. 102-98 (1992), pp. 42 43. TheFederal Reserve has also requested the lifting of the prohibition onthe payment of interest on demand deposits. See, in particular, thestatement by J. Charles Partee, October 27, For a formal definition of depository institutions and transac-tion accounts, see Federal Reserve Regulation D ( Reserve Require-ments of Depository Institutions), sections and At present, required Reserve ratios may be set between 8 per-cent and 14 percent on transaction accounts in excess of $ mil-lion, and between 0 and 9 percent on nonpersonal savings deposits,nonpersonal time deposits with original maturities of eighteenmonths or longer, and net Eurocurrency liabilities.

9 Transactiondeposits of less than $ million, in the so-called low reservetranche, are reservable at 3 percent, while thefirst $ million oftransaction deposits at each depository are exempt from reserverequirements altogether. The Federal Reserve cannot alter the cut-offs for the low Reserve tranche or the exemption, which areadjusted each year according to a formula provided by Reserve BulletinJune 1993interest on required Reserve to hold idle, non-interest-bearing bal-ances is essentially like taxing these institutions inan amount equal to the interest they could haveearned on these balances in the absence of reserverequirements. This forgone interest, or Reserve tax, directly affects only the depository systemand its customers, and not other parts of thefinan-cial system.

10 Hence, it creates an artificial incentivefor depositors and borrowers to bypass the deposi-tory system, and in so doing it may redirect creditflows in ways that impair the efficiency of resourceallocation. In particular, by distorting the relativeprice of transaction accounts at depositories, thereserve tax may induce a smaller level of transac-tion services than what would be ideal for thefunctioning of the economy. The Reserve tax alsocreates an incentive for depositories to expendresources trying to minimize required reserves byfashioning newfinancial products aimed solely atdelivering transactions services without creatingreservable is true for most taxes, determining preciselywho bears the burden of the Reserve tax is determination depends in a complicated wayon the degree of competitive pressure in the mar-kets for deposits and loans and the associated sensi-tivities of borrowers, lenders, and depositories tochanges in prices and interest rates.