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December 1,1993

Federal Reserve Bank of Cleveland

Replacing Reserve Requirements
by E.J. Stevens

M. he significance of the Federal Reserve System's reserve requirements has
been fading for the last 50 years, moving
toward more universal application at less
onerous rates. At the outbreak of World
War n, the requirements applied only to
national banks and to state-chartered
banks that chose to be members of the
System. These institutions had to hold
non-interest-bearing deposits at a Reserve Bank equal to 14 to 26 percent (depending on the bank's location) of their
transaction deposit liabilities plus 3 percent of their time deposits. This was in
addition to coin and currency that banks
kept in their own vaults.
Today, reserve requirements apply to
all depository financial institutions
(DFIs).1 The requirement is only zero
to 10 percent of transactions deposits
(depending on the amount of a bank's
deposits) and zero on time deposits,
with vault cash considered just as good
as non-interest-bearing deposits in
meeting the requirement.
Where will it all end? Most likely, reserve requirements will continue to fade
away until the cost of meeting the requirement no longer acts as a siren song for
avoidance. In the meantime, the search
for alternatives goes on. This Economic
Commentary examines the decline of reserve requirements and the recent flowering of required clearing balances — a
relatively new and rapidly growing feature of Federal Reserve Bank operations
that has the appearance of a substitute for
reserve requirements. Upon closer inspection, however, the required clearing balance arrangement provides an uncertain
alternative, at least as constrained by
existing law.

ISSN 0428-1276

• The Reserve Requirement Tax
Reserve requirements tax DFIs by forcing them to hold non-interest-bearing
cash. The "bite" of the requirement, or
the net tax, comes from the need to
hold more cash than ordinary business
needs would dictate.
One clear business need is to hold
enough coin and currency to stock human and automated teller stations.
Less clear is the need to hold any significant deposit balance at a Federal Reserve Bank. An account relationship
with a Reserve Bank is important for
clearing and settling paper and electronic payments involving other banks
and the Treasury. However, actually
maintaining a balance at the Fed means
leaving funds in an account at the close
of a day's business to sit idle overnight.
A DFI might just as easily maintain a
zero balance, earning interest by wiring
funds out for overnight investment near
the close of business each day.
Perhaps the only reason to keep a substantial voluntary balance in a Fed account overnight would be to ensure an
opening balance large enough to avoid
a temporary ("daylight") overdraft
when making payments the next morning. In the absence of reserve requirements, the alternative to holding an
overnight balance at the Fed would be
to use private systems for making and
clearing payments. A reserve balance
avoids these costs, in effect reducing
the net tax of reserve requirements.

The fading significance of the Federal
Reserve System's reserve requirements has highlighted the search for
alternatives. Required clearing balances, introduced in 1981, perform
much the same functions as reserve
requirements, but offer banks the possibility of earning an implicit market
rate of return. However, with their
volume dependent on both sales of
Federal Reserve priced services and
the level of short-term interest rates,
required clearing balances provide
only an uncertain alternative to reserve requirements. Paying explicit interest, whether on reserves or clearing
balances, would ensure a more predictable system.

In general, however, reserve requirements apparently still impose some net
tax on many DFIs. In a market setting,
these institutions need some offsetting
special advantage if they are to compete
successfully with firms that are not subject to the same requirement. In the historical case of banking, those advantages
might include exclusive rights to make
commercial loans and to provide payment services with deposits, as well as
government restrictions on the number of
competing bank charters and direct access to the lender of last resort.
But no offsetting advantage will eliminate the two-pronged incentive to
avoid the reserve requirement tax.
DFIs have a continuing incentive to
minimize reservable liabilities by designing new methods of financing that
qualify for a lower reserve requirement. Non-DFIs have an incentive to
imitate the special features of banking
while avoiding the tax.
• Evolution of the Fed's
Reserve Requirements
Changes in the structure of the Fed's reserve requirements over the last 80
years reflect the incentive for avoidance. In 1917, member banks were required to maintain reserves that varied
by type of deposit and location of bank.
A three-way location classification, carried over from previous federal requirements for national banks, reflected the
unit-banking environment of the early
twentieth century. Blinking markets
could be defined geographically, and
membership in the Federal Reserve
System was apparently thought to confer special advantages that were more
valuable, the more dense was the concentration of population and industry
near a bank's offices. Requirements
were highest (13 percent) in "central reserve cities," including New York, Chicago, and (briefly) St. Louis. They
were intermediate (10 percent) in about
50 other large urban centers, called "reserve cities," and lowest (7 percent) in
the remaining locations, where smaller
state-chartered "country" banks were
likely to be ambivalent about the advantages of membership in the System.

Reserve ratios had doubled for each location category by the mid-thirties, but the
drift from unit to branch banking in the
postwar period created a growing threat
that banks could avoid high reserve ratios.
That is, as fast as the Fed might redefine
the boundaries of reserve cities, banks
might redesignate country bank branches
as head offices. The size of a bank's deposits officially replaced location in determining reserve ratios in 1972, when
banks were designated country banks —
regardless of location — if they had deposits of less than $400 million. All
larger member banks were classified as
reserve city banks and faced higher reserve ratios.
By 1980, two other distinctions had become the focus of reserve requirement
avoidance. First, member banks faced
the Fed's reserve requirements, while
nonmember banks faced only state reserve requirements, which were typically less onerous. Even some very
large banks were withdrawing from the
Federal Reserve System because of the
cost disadvantage of membership. Second, banks and nonbank thrift institutions were developing deposit products
that competed favorably in the household market with commercial banks'
transactions accounts — without being
subject to the high reserve ratio for
those accounts.
The Depository Institutions Deregulation and Monetary Control Act of 1980
responded to these two forces. All
member and nonmember banks, and all
bank and nonbank depository institutions, became subject to Federal Reserve reserve requirements, graduated
by the size of an institution's deposit
base. The upshot is that all DFIs in the
United States now compete within the
same structure of reserve requirements.
Nonetheless, all must still compete with
foreign DFIs and with non-DFIs that
are not subject to reserve requirements
(such as mutual funds and life insurance
companies) as well as with direqt issues
of securities. It is no accident, then, that
the recent reductions in reserve requirements have focused on improving the
ability of depository institutions to lend.

• Would We Miss Them
If They Were Gone?
Today, federal reserve requirements are
at their lowest levels since the Civil
War.3 Many thousands of small DFIs
(hereafter, simply "banks") and even
some relatively large commercial
banks face no net tax, either because
they have a zero requirement or because they more than meet their requirement with vault cash needed for
routine business.
Why not reduce the tax on the remaining affected banks by lowering the
transactions deposit ratio from 10 percent to the statutory minimum of 8 percent, or perhaps even eliminate the tax
completely by legislative action? Reluctance centers around the potential
evaporation of banks' deposits at the
Fed. That is, while voluntary holdings
of vault cash might be little different
from current holdings, what would become of the inventory of immediately
transferable cash available to banks for
their own use or for lending in the overnight federal funds market?
If the effect of lower reserve requirements were simply to reduce the inventory of Fed deposits, two problems
could arise. Interest-rate signals from
monetary policy would become less
clear because the federal funds rate
would become more volatile in the absence of an inventory of cash upon
which markets could draw. Alternatively, monetary targeting would become less precise if the Fed were to
adopt a reserves-based approach to targeting money. Second, without any inventory for payors to draw on directly
or through borrowing in the money
market, risk exposure would increase
in the payment system. Payment delays
or defaults would be more likely to
bring the payment system to a halt as
banks sought to negotiate settlements.5



Billions of dollars
















a. Required balances equal required reserve balances plus required clearing balances.
SOURCE: Board of Governors of the Federal Reserve System.

Monetary policy implementation and
payment system risk are important matters, but there are ways to compensate
for lack of an inventory of immediately
available funds. For example, banks in
the United Kingdom have operated
with no reserve requirements and with
virtually no balances at the central
bank for over a decade. Instead, the
Bank of England engages in frequent
open-market operations to provide a
"just-in-time" source of funds.6 Likewise, the Canadian banking system is
currently adjusting to the elimination
of reserve requirements. In this new
framework, the Bank of Canada makes
direct loans or advances that ensure a
just-in-time source of funds to institutions needing to cover temporary deficits in their cash positions.
Furthermore, removing reserve requirements may have a more limited effect on
banks' demand for balances in the United
States, even though the British and Canadians have learned to live without an inventory of immediately available funds.
After all, in addition to vault cash, only
about $27 billion of the $34 billion of
bank balances at Reserve Banks is required reserve balances. The remaining
$7 billion includes about $1 billion of ex-

cess reserves as well as $6 billion of
required clearing balances. These balances have grown rapidly enough to
offset almost two-thirds of the $6 billion decline in required reserve balances that has taken place over the last
three years (see figure 1).
• Clearing Balance Requirements
About 5,000 banks now maintain required clearing balances at the Federal
Reserve Banks. These range from
small retail depositories with a $25,000
minimum requirement to giant money
center institutions with clearing balance requirements of several hundred
million dollars. These requirements differ from reserve requirements in three
significant ways. First, a bank's agreement to meet the requirement is typically a business decision, not a legal
necessity. Second, the amount of the requirement is unrelated to the amount of
a bank's deposit liabilities. And third,
the rate of return on a clearing balance
can be about equal to the federal funds
rate, not zero, if the bank uses its earnings to pay for services it buys from a
Federal Reserve Bank.

A bank may have either or both of two
motivations for holding a required
clearing balance. One is to save money
on priced services purchased from a Reserve Bank. This saving is possible if
the bank can maintain a positive spread
between the earnings credit rate received on its clearing balance and the
average rate it pays for funds invested
in the clearing balance. The earnings
credit rate is based on the average of all
the rates at which overnight federal
funds trade in the market each day.
These rates can include quality spreads,
day-of-the-week effects, and other
anomalies. Thus, a high-quality bank
with confidence in its ability to "buy
low and sell high" in the funds market
might expect to earn a positive spread
on a required clearing balance.
A second and more fundamental reason
for banks to maintain a required clearing balance is to reduce the possibility
of account overdrafts. The Reserve
Banks penalize overnight overdrafts at
a 10 percent annual rate (or higher) and
are moving toward a regime of explicit
fees for excessive daylight overdrafts,
starting in April 1994. Moreover, even
if penalties and fees don't induce a bank
to hold a larger balance, a Reserve

Bank may insist that it do so as a

means of overdraft protection.
In many respects, a required clearing
balance is comparable to the traditional
compensating balance that a respondent
bank or commercial customer might
maintain with its bank. A bank reaches
an agreement with its Reserve Bank about
the average balance it will maintain
during a required reserve maintenance
period, in addition to any required reserve balance and allowable carryover
of a surplus or deficiency. At the end of
the period, the bank is penalized if its
actual maintained balance, net of whatever amount is needed to satisfy its reserve requirement, has fallen short of
the required clearing balance by more
than a penalty-free band. On the other
hand, the bank receives earnings credits on the amount by which its maintained balance has exceeded the amount
needed to satisfy the reserve requirement, up to the required clearing balance plus the penalty-free band.
These earnings credits accumulate for
use in offsetting charges for priced services, but expire after 52 weeks.''
• A Potential Replacement
for Reserve Requirements?
Basing a bank's reserve requirement on
payment system activity rather than on its
deposit base is not a new idea. What's
different about the required clearing balance arrangement, in addition to earnings
credits, is the potential link between the
size of a bank's required clearing balance
and the account overdrafts it would otherwise generate. Overdrafts are one indicator of a bank's contribution to payment
system risk, and required clearing balances
reduce this risk. Of course, a bank can
avoid a required clearing balance, but
only by shifting its payment business
from the Fed to correspondent banks, or
directly to either private payment networks or private same-day wire transfer
networks such as CHIPS.
Replacing reserve requirements with required clearing balances could be safe,
then, as long as all the private alternatives had risk protections equivalent to
those required by the Fed — a reasonable
expectation, since the Fed has regulatory

authority over payment-system-risk aspects of private networks. Equivalence
of the cost of risk protection, however,
might be impossible to achieve because
of earnings credits. For example, the
CHIPS network limits each participating bank's use of daylight credit in
much the same way that the Fed limits
daylight overdrafts. In addition, CHIPS
requires participants to maintain a settlement guarantee fund invested in
earnings assets whose income benefits
A required clearing balance differs
from participation in the CHIPS guarantee fund in one crucial respect. The
positive return on required clearing balances is realized only through a bank's
use of the Fed's priced services. There
is no mechanism to ensure that charges
for the priced services a bank wants to
buy will exhaust the earnings credits
the bank receives on its required clearing balance. Unused earnings credits
do reduce prices of the Fed's services,
because such credits are deducted from
the costs of production. But an individual bank will see balances that earn unused credits as no different from the
net tax of reserve requirements. The
problem is simply that the Federal Reserve Banks cannot pay explicit interest on the balances that banks hold
with them. 13
It is true that, in the aggregate, earnings
credits don't exhaust charges for Reserve Banks' priced services. If this
were also true of each individual bank,
there might be room to replace required
reserve balances with required clearing
balances. However, the aggregate statistic masks substantial variation among
individual banks. A study of banks in
the New York Federal Reserve District
found a tendency toward a bipolar distribution of large institutions.' One
group placed little or no reliance on required clearing balances to pay for
priced services and therefore could
profitably add to required clearing balances in place of required reserves.

The other group was already relying
heavily on earnings credits, holding
close to the "maximum useful balance"
at which charges for priced services exhaust earnings credits. All else equal,
these banks would be no better off replacing required reserve balances with
required clearing balances, because they
would be unable to realize the income po1
tential of additional earnings credits.
An important unanswered question is,
would these "exhausted" banks increase their use of Fed priced services
in order to realize income on clearing
balances, or would they increase their
use of private priced services to avoid
the need for so large a clearing balance? Equally important, note that overdraft protection is inversely proportional to the level of the federal funds
rate. Charges for the Fed's priced services totaled about $750 million in
1992. If all of these charges had been
paid with earnings credits when the
funds rate was 3 percent, banks would
have had to hold $25 billion of required clearing balances. But if the
funds rate had risen to 6 percent, banks
would have needed balances of only
$12.5 billion.
• Concluding Comment
It seems indisputable that a payment
system and a financial system are safer
and less volatile when banks hold more
rather than less cash. But how can that
safety be encouraged? The impermanence of reserve requirements results
from their net tax, which acts as an incentive for avoidance. Those subject to
the tax search for ways to get around it
even while those not subject to the tax
search for ways to compete tax-free.
Required clearing balances show some
promise as a replacement for reserve requirements. They too can encourage
banks to hold balances of immediately
available funds as a cushion to fall
back on when payments are unexpectedly delated. The availability of this '
cash fund helps to ensure both a safe
flow of payments and a stable monetary policy signal in the money market.

Banks hold a relatively small amount
of clearing balances today. The important question, however, is how they
might respond to further reductions in
reserve requirements. The ability to
earn a market rate of interest would
make required clearing balances an attractive option for institutions seeking
to avoid overdrafts, especially with the
anticipated introduction of charges for
daylight overdrafts this year. However,
as matters now stand, the Reserve
Banks cannot pay explicit interest on
required clearing balances, but only
earnings credits against charges for
priced services.
Especially in times of high interest rates,
a bank may need to maintain a balance
on which earnings credits exceed charges
for priced services. Under these circumstances, the future of required clearing
balances is not clear. If banks were to
shift their patronage away from private
providers of payment services and to the
Reserve Banks, increased charges would
be covered by otherwise unused earnings
credits. Just as plausibly, shifting patronage away from the Reserve Banks and to
private providers might reduce the size of
the clearing balance required.
Paying explicit interest, whether on reserves or clearing balances, would ensure a more predictable system.

• Footnotes
1. Depository financial institutions include
commercial banks, mutual savings banks,
savings and loan associations, credit unions,
agencies and branches of foreign banks, and
Edge corporations.
2. See E J. Stevens, "Removing the Hazard
of Fedwire Daylight Overdrafts," Federal Reserve Bank of Cleveland, Economic Review,
vol. 25, no. 2 (1989 Quarter 2), pp| 2-10.
3. Requirements are zero for all nonpersonal
time deposits (reduced from 3 percent in December 1990, within a legislated range of
zero to 9 percent) and zero, 3, and 10 percent
on transactions deposits (reduced from zero,
3. and 12 percent in April 1992, within a legislated range of 8 to 14 percent on deposits in
excess of the 3 percent tranche).
4. "The Garn-St Germain Depository Institutions Act of 1982 ... requires that $2 million
of reservable liabilities of each depository institution be subject to a zero percent reserve
requirement. The Board [of Governors] is to
adjust the amount of reservable liabilities
subject to this zero percent reserve requirement each year for the succeeding calendar
year by 80 percent of the percentage increase
in the total reservable liabilities of all depository institutions, measured on an annual basis
as of June 30. No corresponding adjustment
is to be made in the event of a decrease.
"The Monetary Control Act of 1980 requires that the amount of transactions accounts against which the [lowest nonzero] 3
percent reserve requirement applies be modified annually by 80 percent of the percentage
change in transactions accounts held by all
depository institutions, determined as of June
30 each year." (Federal Reserve Bulletin,
August 1993, table 1.15) The amount was set
at $46.8 million in December 1992.
5. In addition to monetary policy and payment-system-risk repercussions, lower reserve requirements would reduce Treasury
revenue. The Fed remits to the Treasury almost all of the income earned on securities financed by bank reserves. However, the drop
in Treasury revenue would be only about
two-tenths of 1 percent even if all current reserve deposits were eliminated. See the appendix to E J. Stevens, "Is There Any Rationale for Reserve Requirements?" Federal Reserve Bank of Cleveland, Economic Review,
vol. 27, no. 3 (1991 Quarter 3), pp. 2-17.

6. See E.J. Stevens, "Comparing Central
Banks' Rulebooks," Federal Reserve Bank
of Cleveland, Economic Review, vol. 28, no.
3 (1992 Quarter 3), pp. 2-15. See also Bruce
Kasman, "A Comparison of Monetary Policy
Operating Procedures in Six Industrial Countries," in Marvin Goodfnend and David H.
Small, eds., Operating Procedures and the
Conduct of Monetary Policy: Conference
Proceedings, Board of Governors of the Federal Reserve System, special issue of Finance
and Economics Discussion Series, March 1993.
7. See Donna Howard, "The Evolution of
Routine Bank of Canada Advances to Direct
Clearers," Bank of Canada Review, October
1992, pp. 3-22.
8. The earnings credit rate varies with a
bank's marginal reserve requirement ratio to
avoid giving a competitive advantage to Reserve Banks and banks with low reSsrve requirement ratios. See EJ. Stevens, "Required
Clearing Balances," Federal Reserve Bank of
Cleveland, Economic Review, vol. 28, no. 4
(1993 Quarter 4), pp. 2-14.
9. Daylight overdrafts in excess of a preestablished amount trigger conversations
with a bank's management and, starting in
April, will result in a fee. Overnight overdrafts are penalized at a rate equal to the
greater of the discount rate plus 2 percent, or
10 percent.
10. Earnings credits are not added to the balance in the account, but accumulate for use
on a first-in/first-out basis. They cannot be
used to pay penalties for clearing balance deficiencies or for charges related to nonpriced
service functions, such as penalties for deficient required reserve balances, interest on
discount window loans, and cost recoveries
for providing accounting information services. Penalties are 2 percent on the first 20
percent and 4 percent on the remainder.

11. The Reserve Banks set prices for services that, by law, must cover costs. Required
clearing balances enter priced services costs
in two largely offsetting ways. Total cost includes the earnings credits Reserve Banks
grant on clearing balances ($177.8 million in
1992), reduced by a cost offset for unused
earnings credits. Total cost also includes a
cost offset for the income that the Reserve
Banks could earn on assets financed with required clearing balances, imputed at the
coupon-equivalent yield on three-month
Treasury bills ($180.2 million in 1992).
These items are reported as components of
"Other income and expenses" in the pro
forma income statement for Federal Reserve
priced services, published in the Board of
Governors' Annual Report.
12. For example, see Neil Jacoby, "The
Structure and Use of Variable Bank Reserve
Requirements," in Deane Carson, ed., Banking and Monetary Studies, Homewood, 111.:
Richard D. Irwin, Inc., 1963.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:
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Material may be reprinted provided that
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13. The only statutory provision for explicit
interest on reserve deposits arises in a provision for a supplemental reserve requirement
of up to 4 percent of transaction accounts. If
imposed, these reserves would receive earnings at a rate not to exceed the rate earned on
the Federal Reserve System's portfolio of securities in the previous calendar quarter. The
supplemental reserve requirement can be imposed only if "the sole purpose of the requirement is to increase the amount of reserves
maintained to a level essential for the conduct of monetary policy" and not to reduce
the cost of the basic reserve requirement, nor
to increase the amount of balances for clearing purposes." [Federal Reserve Act, Section

E. J. Stevens is an assistant vice president
and economist at the Federal Reserve Bank
of Cleveland.
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

14. See Spence Hilton, Ari Cohen, and Ellen
Koonmen, "Expanding Clearing Balances,"
in Ann-Marie Meulendyke, ed., Reduced Reserve Requirements: Alternatives for the Conduct of Monetary Policy and Reserve Management, Federal Reserve Bank of New
York, April 1993, pp. 109-35.

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