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July 15, 1991
eCONOMIG
GOMMeiMTCIRY
Federal Reserve Bank of Cleveland
Do Excess Reserves
Reveal Credit Crunches?
by Joseph G. Haubrich
A he anticipated economic recovery is
haunted by the specter that banks, under
pressure from regulators and shareholders, will make too few loans to reignite
the economy. Like a phantom, this socalled credit crunch eludes attempts to
pin it down, quantify it, or dissect it.
Concern about a credit shortage surfaced in media accounts in early 1990,
even before the recession materialized.
Businesses complained that banks were
less willing to lend money, and this dissatisfaction was interpreted as a sign of
a credit crunch. "Credit crunch" is an
admittedly nebulous term indicating a
substantial reduction in credit—one
whose dimensions extend well beyond
rising interest rates to nonprice factors
that depress investment.
The appropriate policy response to
signs of a credit crunch depends on the
source of the problem. For example, if
restrictive monetary policy is seen as
the culprit, then easing is the correct response, as long as other factors remain
constant. If banks are flush with funds
but are reluctant to lend, then their lending policies and those of their regulators
warrant scrutiny. If businesses are simply not seeking loans because of a poor
economic outlook, then that is an altogether different matter.
Difficulty in determining whether we
are experiencing a credit crunch cannot
be blamed on insufficient data, because
a variety of credit numbers are available, including bank loans, mortgages,
ISSN 0428-1276
domestic nonfinancial debt, and consumer installment loans. Instead, the
problem lies in disentangling the many
influences on credit, including demand,
supply, and monetary and fiscal policy.
Those who have declared that a crunch
is under way, alleging that reduced lending is the result of a lower supply of
funds from banks, have merely chosen
one of many possible explanations.
One way to distinguish the effects of
monetary policy from those of bank
lending practices is to look at excess
reserves, or funds that banks hold in
excess of those required by law. Allan
Meltzer, the distinguished CarnegieMellon economist, and his colleagues
on the Shadow Open Market Committee use this approach to label the recent
credit crunch reports as "nonsense."
Meltzer argues that if banks were reluctant to lend (because of higher capital
requirements, lower returns, or fiendish
regulators), their reservations would
show up as an increase in excess reserves. This uptick has not occurred.
Meltzer's position fails to take into account the fact that the excess reserve
level depends directly on the Federal
Reserve's monetary policy procedures.
This Economic Commentary shows that
excess reserves can clearly identify a
credit crunch only under very restrictive
conditions: First, the Federal Reserve
must be targeting only the monetary
aggregates, and second, it must remain
firm in its commitment to these targets
over time.
Does an increase in excess reserves
indicate that a credit crunch is under
way, as one recent report suggests?
The author examines this issue from
both a current and a historical perspective and finds that because the
level of excess reserves depends
directly on Federal Reserve policy,
this measure is generally an unreliable indicator of credit conditions.
• How Might Excess Reserves
Indicate a Credit Crunch?
Banks are required to hold reserves
(cash on hand and deposits with the Federal Reserve) equal to about 12 percent
of their transactions deposits, thereby
limiting the amount of money they can
lend. Thus, it is monetary policy, in the
form of reserves that the Fed injects into
the system, that restricts lending. If the
Fed adds reserves, the banking system
normally increases lending and deposits
until the reserves required on the resulting deposits match the newly injected
reserves. (Banks borrowing from the
Fed and the public's demand for cash
complicate the matter somewhat, but
the basic premise holds.) Because interest is not paid on reserves, banks generally try to hold as few as possible.
During a credit crunch, however, banks
may decide not to make these additional
loans. For the banking system as a
whole, this means holding excess reserves. This is a simple matter of logic
and arithmetic. Normally, banks would
increase their loans, and thus their deposits, until the new reserves totaled 12
percent of the new deposits. If banks
made fewer loans and created fewer deposits, reserves would then amount to
more than 12 percent of total deposits.
As the Shadow Open Market Committee report puts it, "If banks have become reluctant to lend, as exponents of
the credit crunch suppose, banks' excess reserves would have increased."
Although this simple logic is true for
the banking system as a whole, any one
particular institution may not be holding
excess reserves. Banks may sell their
surplus funds to one another through
the federal funds market, or they may
exchange them for Treasury bills or
other securities. Still, reserves that are
sold or transferred do not vanish; they
just reappear at other banks.
• Federal Reserve
Operating Procedures
Although this reasoning is insightful, it
holds only if the Federal Reserve is unwavering in its commitment to target
the monetary aggregates, not interest
rates. For instance, if the Fed attempted
to maintain a range for the federal funds
rate (the interest rate banks charge each
other for overnight loans) by adding or
draining reserves, there would be no
direct link between excess reserves and
credit availability. Therefore, to present
a complete picture, we must address
the questions of when and why the
Fed chooses to intervene in the market
for bank reserves.
The answers are critical in determining
whether excess reserves can signal a credit crunch, particularly if the Fed is targeting interest rates (specifically, the federal
funds rate). Because the open-market
operations that add and drain reserves
can absorb any excess reserves resulting
from bank lending practices, the Federal
Reserve can prevent the accumulation of
surplus funds. In other words, monetary
policy can mask the ability of excess
reserves to signal a credit crunch.
Let's trace how this could happen. Suppose there is a credit crunch that causes
banks to lend less, perhaps because of
more-stringent capital requirements, increased regulatory pressure, or even
"animal spirits." As a result of the
drop-off in loans and thus in deposits,
banks need to hold fewer reserves. As
the demand for reserves falls, excess
reserves begin to increase. The reduced
demand (glut of reserves) lowers the
price of borrowing in the federal funds
market as banks compete to place their
extra reserves with the fewer number
of banks that need them. This results in
downward pressure on the federal
funds rate.
The story does not end here, however, if
the Federal Reserve targets a particular
federal funds rate and acts to offset the
drop by balancing the reduced demand
for reserves with a reduced supply. As
the Fed drains reserves (decreases supply), the quantity demanded will once
again equal the quantity supplied at the
targeted interest rate.
Many observers believe that this is in
fact a key aspect of the way the Federal
Reserve System currently operates, at
least in the short run. The official domestic policy directives, issued to the
Federal Reserve Bank of New York
(which carries out the open-market operations that add and drain reserves), are
couched in terms of "degree of pressure
on reserve positions."' It is certainly
possible to see how a significant amount
of excess reserves would have to be
absorbed to maintain this pressure.
Indeed, as Meltzer points out, reserve
growth has been quite sluggish recently, with total reserves showing no significant trend between January 1990
and March 1991 (see figure 1). One
possible interpretation—the one that
Meltzer offers—is that the Fed has kept
reserve growth low and thus has caused
the slow growth in loans and deposits.
This view makes sense if the Fed is in
fact targeting monetary aggregates such
as the money supply.
The alternative, that in the short run the
System targets the federal funds rate
rather than the monetary aggregates,
characterizes the Fed as more of a reac-
tor than an actor in this drama. Rather
than causing the credit crunch, low reserve growth in this scenario is the
result of the Fed's reaction to the effects of lower loan activity in the federal funds market. As a by-product,
Federal Reserve policy would conceal
the ability of excess reserves to signal a
credit crunch.
• Evidence
As Meltzer points out, the ratio of excess reserves to required reserves has
remained low since the credit crunch
issue first surfaced early last year, generally registering less than 2 percent between January 1990 and March 1991
(see figure 2). Moreover, excess reserves
topped $2 billion in only one month
over this period, and mostly remained
below $1 billion.
Even if that $1 billion of surplus funds
were fully utilized (that is, if loans were
increased enough so that the entire $1
billion became required reserves), total
loans would rise by no more than $8.3
billion, or not quite four-tenths of 1 percent of the more than $2 trillion loaned
by U.S. commercial banks today. Because banks hold some excess reserves
to satisfy their customers' demand for
cash and to meet other obligations, the
actual amount could be significantly
less. Even the bulge in reserves that occurred near the end of 1990 does not indicate a credit crunch, but rather reflects
the annual year-end increase in demand
for excess reserves and the lagged
adjustment to the reduction in reserve
requirements on nontransactions
accounts at banks, which the Federal
Reserve adopted in December 1990.
One way to determine whether excess
reserves are a reliable gauge of credit
crunches is to look at how well they
have performed during previous credit
shortfalls. The crunch of 1966 resulted
from Federal Reserve policies designed
explicitly to restrict credit. The System accomplished this by curbing the
growth of total reserves and by applying
Regulation Q, which established an
interest-rate ceiling on bank deposits.
Restricted credit drove up interest rates,
and in June 1966, the rate on prime
FIGURE 1
FIGURE 2
TOTAL AND REQUIRED RESERVES, 1990-91
Billions of dollars'1
551
EXCESS RESERVES AND EXCESS
RESERVES/REQUIRED RESERVES, 1990-91
Billions of dollars2
0.04
50
Total reserves
Excess
reserves/
required
reserves
Required reserves
45
40
J
F
M
A
FIGURE 3
M
M
A
S
O
N
D
J
0.0
F M
1991
EXCESS RESERVES AND EXCESS
RESERVES/REQUIRED RESERVES, 1966-67
Billions of dollars2
0.5|
F
J J A
1990
M
Excess reserves/required reserves.
J
J A
1966
S
O
N
D
J
i_
J
F
M
A
FIGURE 4
Ratio
0.03
M
J J A
1990
S
O
N
D
J
L
A.
F M
1991
EXCESS RESERVES, 1970
Billions of dollars'1
0.30
F
1967
a. Not seasonally adjusted.
SOURCE: Board of Governors of the Federal Reserve System.
commercial paper rose above the rate
banks could pay on certificates of deposit (CDs) and on other large deposits. The secondary market rate on negotiable CDs, which could be resold in
the open market, also surpassed the
Regulation Q maximum of 5.5 percent.
When this happened in 1963, 1964, and
1965, the Fed responded by increasing
the Regulation Q ceiling. In 1966, however, the System held the line in an effort to curtail credit even further.
As one would expect, this hard-line policy resulted in excess reserves showing
little, or even negative, growth. Figure
3 plots excess reserves and the ratio of
excess reserves to required reserves
from February 1966 to February 1967.
Note that the ratio was significantly
lower in 1990 (figure 2) than in 1966—
a time of acknowledged monetary restraint. Because today's economic
environment is different from that of
the 1960s, however, it is difficult to
make direct comparisons. Lower interest rates in the 1960s meant that banks
had less incentive to conserve their surplus funds. Moreover, in the earlier decade the Federal Reserve targeted excess
reserves directly through manipulating
"free reserves" (the difference between
excess reserves and discount loans
from the Federal Reserve).
The Federal Reserve responded by suspending Regulation Q ceilings and by
using the discount window and openmarket operations to guard against liquidity pressure. This action suggests
that the Fed was not trying to drain
reserves, and hence that increased excess reserves might have revealed
banks' reluctance to lend.
The credit crunch associated with the
1970 Perm Central bankruptcy has a
somewhat different history. Although
reserve growth slowed once again and
market interest rates rose above Regulation Q levels, banks were able to accommodate this pressure to some degree by
issuing commercial paper. When Penn
Central filed for bankruptcy on June 21,
it had about $82 million of outstanding
commercial paper. This naturally placed
great stress on the market; firms found
it hard to borrow commercial paper, yet
had trouble turning to banks, which
faced similar funding problems.
Although excess reserves never rose
significantly during the Penn Central
crisis and thus were not infallible indicators of a credit crunch, they did
show a substantial increase that June
(see figure 4). Nonetheless, closer examination shows that these surplus
funds increased even more in September—several months after the crisis
had passed. Moreover, weekly excess
reserves also showed an unexpected
pattern, as June's uptick commenced
before the Penn Central crisis began.
The Fed's quick action apparently overcame banks' reluctance to lend and
0.03
0.02
0.01
rerouted credit from the commercial
paper market to the banks. Thus, because the Fed responded to the crisis
by shifting its monetary policy, excess
reserves again proved to be an unreliable indicator of credit conditions.
• Conclusion
Pinpointing the nature, the severity, and
the source of a credit crunch is difficult.
One recent report attempts to track current credit conditions by examining
whether banks are holding an unusually
large amount of reserves, which the
author assumes would signal a reluctance to lend. Although this approach
shows no sign that a credit crunch is
under way, evidence presented above indicates that excess reserves are an unreliable indicator of credit conditions.
We are thus left with the unwelcome
prospect of being unable to state with
certainty whether a credit crunch exists.
The advantage of identifying a credit
crunch goes beyond knowing whether
the specter is real: Appropriate monetary
policy responses depend on understanding the source of a credit shortfall.
The ability to distinguish monetary policy effects from the effects of credit
supply and demand shifts is crucial to
determining whether the Federal Reserve or the banking system lies behind
tight credit. The distinction has important policy consequences. If restrictive
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Federal Reserve policies are responsible, then injecting more reserves could
help to alleviate the credit shortfall. But
if a credit crunch exists because banks
are reluctant to lend, then merely increasing reserves will not eliminate the
problem. This uncertainty means that
the Federal Reserve—and the public—
must rely on sources other than excess
reserves to determine whether the disquieting shadow of a credit crunch will
materialize into something more
ominous or just fade away.
•
Footnotes
1. See Allan H. Meltzer, "There Is No Credit Crunch," The Wall Street Journal, February 8, 1991, p. A-14; and the Shadow Open
Market Committee, Policy Statement and
Position Papers, March 3—4, University of
Rochester Public Policy Working Paper
Series, pp. 3-10.
2. Because assessing a loan's risk and return
depends partly on intangible factors, lending
can be affected by sudden shifts in optimism
or pessimism ("animal spirits") in the banking industry.
3. See the Federal Reserve Board's November 1990 directive, reported in "Record of
Policy Actions of the Federal Open Market
Committee," Federal Reserve Bulletin, vol.
77 (February 1991), pp. 98-103.
4. This does not mean that the Federal
Reserve cannot or will not take action to offset a recession or a credit crunch. The Fed
can reduce the targeted interest rate (and has
done so) in order to increase reserves and the
money supply.
5. Another useful indicator, the monetary
base, grew substantially during this time, but
the increase stemmed from larger holdings of
currency. Because this currency was held by
the public and not by banks, it could not support bank lending. Thus, the monetary base
gives a distorted view of available credit
during this period.
6. See Albert E. Burger, "A Historical
Analysis of the Credit Crunch of 1966,"
Federal Reserve Bank of St. Louis, Review,
vol. 51 (September 1969), pp. 13-30.
7. See William C. Melton, "Crisis!" in
Inside the Fed: Making Monetary Policy,
Homewood, Dl.: Dow Jones-Irwin, 1985,
pp. 153-70.
8. See "Liquidity and Credit in the Second
Quarter," Federal Reserve Bank of New
York, Monthly Review, vol. 52 (August
1970), pp. 182-86.
9. The week before Perm Central filed for
bankruptcy, excess reserves stood at $273
million. This figure dropped to $88 million
during the week of the crisis and then returned to $273 million the following week.
Joseph G. Haubrich is an economic advisor
at the Federal Reserve Bank of Cleveland.
The views stated herein are those of the
author and not necessarily those of the
Federal Resen'e Bank of Cleveland or of the
Board of Governors of the Federal Reserve
Svstem.
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