The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FRBSF
WEEKLY LErrEI
September 8, 1989
Eliminating Reserve Requirements
Banks in most countries are required to hold
non-interest earning deposits at their central
banks. These deposits, calledrequired reserves,
figure importantly in the process of monetary
control. These balances also are used to effect
payments between banks and, thus, play an
important role in the interbank payment system.
Moreover, because these balances do not earn
interest, they affect the competitive balance
between bank and non-bank financial institutions.
Some countries have stopped imposing binding
reserve requirements. In 1988, for example, Switzerland adopted a reserves accounting procedure
that is tantamount to a zero-reserve requirement.
The Government of Canada has adopted a policy
aimed at eliminating reserve requirements,
which will be implemented in the next year. The
purpose of this Letter is to explore the issues
involved in a zero-required-reserves policy.
The role of reserve requirements
The traditional view of monetary policy assigns
reserve requirements a central role in monetary
control. In this view, the behavior of prices and
output in the economy is linked to the quantity
of transaction-type deposits ("money") in the
economy. The central bank influences this quantity indirectly by manipulating the supply of
reserves and relying on a stable reserves/deposits
link to generate the desired effect on the money
stock. It can implement this policy by targeting
either the money stock itself or the interest rate.
If the level of transactions deposits is, in fact, the
important monetary variable, it may be desirable
to fix the reserves/deposits ratio through a reserve
requirement. By imposing a reserve requirement,
the central bank can influence banks' desire to
hold reserves and in this way gain better control
over the link between its reserves policy and the
money stock or interest rates.
In order to limit instability that voluntary
reserves-holding behavior could introduce into
the relationship between reserves and the money
stock, the required reserves ratio must be higher
than the voluntary level of reserves. In addition,
reserves balances must earn less than the market
rate ofinterest to discourage voluntary holding of
excess reserves, which also could disturb the
fixity of the reserves/deposit ratio.
Zero required reserves
Some economists have pointed out, however, that
even without a reserve requirement, the banking
system still would be willing to hold some non"
interest earning reserves. Vault currency, for
example, would continue to be held by banks
against uncertain cash needs. Likewise, banks
would continue to maintain some "deposits" at
the central bank since these balances provide the
"good funds" that banks use to settle transactions among themselves.
From the traditional viewpoint, the advisability
of a zero-required-reserves policy thus depends
on whether the voluntarily-held level of reserves
would be stable or whether it would move in
such a way as to makeit difficultto manipulate
the money stock or interest rates. Some economists have argued that the demand for reserves
is sufficiently stable to permit the conduct of
monetary policy in a zero-reserves enVironment.
Others believethat the demand for reserves by
banks in such an environment is so unpredictable as to make effective targeting of the money
stock or interest rates very difficult.
More fundamentally, however, other economists
have debated whether the reserves/deposits link
is even central to managing the stability of the
economy. Eugene Fama, among others, argues
that it is not the quantity of transactions deposits
("money") that determines stabilityof prices in
an economy, but rather the level of the monetary
base (bank reserves and currency held by the
public). In this view, a stable monetary base is
important, but a stable relationship between
reserves and deposits is not. As long as the
monetary base can be manipulated by the central bank, formal reserve requirements are not
necessary.
FABSF
Reserves and banking markets
From the standpoint of monetary policy alone,
therefore, it is not possibleto.conclude whether
reserves should be regulated; the conclusion
rests on one's views about monetary theory and
the nature of the demand for reserves in the
absence of reserve requirements.
Fromthe standpointof banking market considerations, however, the choice is quite c1~ar.
A high reserve requirement, enforced by nonpayment of interest on reserves, severely penalizes depository intermediaries. A three-percent
reserve requirement, for example,translat~s into
more than a 25 basis-point cost disadvantage in
the loan marketat the current level of interest
rates. That's enough to affect banks' market share
significantly relative to non-bank competitors.
(At present, reserverequirements in.the U.S.
range from three to 12 percent.)
Evidence of the. distorting effects of reserve
requirements in financial markets is readily
available. For example, differentials between the
reserve requirements imposed on members and
on noncmembers of the Federal Reserve System
cau~ed distortions in thepatt~rns of bank charteringin the U.S. in the 1970s. (The differential
was eliminated by the Depository Institutions
Der~gulation and Monetary Control Act of 1980.)
Reserve requirem~nts also have been linked
to distortions in the level of bank- versus
nonbank-intermediation in the U.S. The size of
the banking sector relative to that of the nonbank
financial sector has fluctuated with the size of
regulatory taxes, including reserve requirements.
A study of regulatory taxes by Pavel and Baer
suggests that each basis point of "reserve tax"
isassociated with a 1.5 percent decline in the
market share of banks.
"\
Other countries have observedsimilar phenomena.ln Germany, reserve requirements are
employed ~xtensively and vary considerably
depending upon the size and type of deposit.
Differences in the performance of various
segments of thebankingindustry appear to be
associated with differences in the effective
burden of these. reserve requirements. The slower
growth of the big commercial banks relative to
that of the savingsbank and cooperative bank
sectors in recent years may be due to effective
reserve ratios for the latter groups that are as
much as 12 percentage points lower than those
for the big commercial banks.
International differences in reserve "taxes"
also may influence the market shares enjoyed by
banks of various nationalities in domestic loan
markets. Offshore banking offices and special
banking facilities that are exempt from the
domestic reserves burden are manifestations of
international differences in reserves treatment. As
Canada implements its zero-reserves policy, the
nature of U.s./Canadian banking competition
likely will change, particularly in the banking
markets near the border, since the new u.s.Canada trade pact liberalizes cross-border
financial activity.
In addition to its effects on market structure,
required reserves policy distorts the nature of
payments transactions and technology. Because
required reserve balances are high, banks have
little incentive to economize on the use of such
balances in the payments process. (Moreover,
because banks currently are not charged for overdrafts of these balances, banks have even less
incentive to manage payments balances efficiently.) The contracts that are employed in
foreign exchange and securities transactions
reflect this bias; these contracts often require
large gross flows of funds between banks when
small net exchanges would do.
Finally, to the extent that high reserve requirements foster the development of substitutes for
reservable bank deposits (such as liquid shares
in mutual funds, for example), the policy can
becomeself-defeating over time. These innovations, in effect, make more elastic the relationship between reserves, money, and economic
activity-the very relationship on which the
rationale for regulating reserves is based.
Would zero reserves work?
Switzerland offers one of the few examples of a
zero-required-reserves regime. In January 1988,
banks effectively were freed from having to meet
minimum reserve requirements. The Swiss experience with managing monetary policy and the
payments system after this reform is instructive.
First, it is interesting to observe the equilibrium
"voluntary" reserve/deposit ratio. Prior to the
policy change, total reserves in the Swiss banking system totalled about 9 billion Swiss francs.
Following implementation of the new reserve requirement, reserves fell steadily for about a year,
reaching a level of just above 2 billion francs in
June of this year. Thus, for the Swiss economy at
least, the equilibrium quantity of excess reserves
appears to be somewhere in the vicinity of one
to two percent of transactions-type deposits. (The
equilibrium would have been lower still if the
Swiss had not simultaneously eliminated daylight
overdrafts.)
Second, the Swiss experience illustrates the
flexibility of payments system practices and technology. Under the previous regime in which the
reserve requirement ratio was high, banks had
little incentive to economize on the use of their
clearing balances. The required balances apparently were far more than would be justified by a
bank's need to maintain a settlement balance or
a contingency against unexpected liquidity
needs. Thus, the turnover rate for these balances
was only about three times daily. The turnover
rate since implementation of the new reserves
policy has climbed steadily and presently stands
at over 50 times daily. Such changes illustrate
vividly the magnitude of the effects of regulated
reserves policy on payments conventions.
Finally, the effects of the changes on the conduct
of Swiss monetary policy must be considered.
Since 1979, Swiss monetary control procedures
have emphasized the monetary base, rather than
the money supply or interest rates. The willingness of Swiss banking authorities to eliminate
required reserves is consistent with this policy.
perspective.
Prior to the reform, the authorities had been able
to maintain actual base growth close to their two
to three percent target, as the chart indicates.
The target growth rate for the base for 1988 had
been three percent, but because of the largerthan-expected decline in reserves holding, the
base actually fell 3.9 percent over the year. Thus,
the Swiss central bank may have overestimated
the economy's need for liquidity reserves, and
allowed monetary policy to be too loose in 1988,
causing a sharp decline in interest rates in early
1988, and a subsequent decline in the value of
the Swiss franc.
Annual Change in Adjusted Monetary Base
Switzerland, 1984·1989
Percent
6
4
2
o
-2
-4
'---_--l.~_---'--
1984
1985
_ _- ' -_ _.l.-_
1986
1987
1988
___'_ _-.l..
-6
-8
·10
.12
1989
Swiss economists expect the monetary authorities
eventually to return to a more conservative monetary policy. And it is clear that monetary policy,
rather than the treatment of reserves per se, is
responsible for the somewhat reduced stature
of the Swiss franc in world markets in recent
months. Nonetheless, the Swiss experience
illustrates the transition problems that can be
encountered with a change in reserves regime.
Time for a careful look
Required reserves policy long has been an important source of distortions in the structure of
the financial industry. Although the specter of
impaired monetary control has made central
banks reluctant to eliminate required reserves, it
is not at all clear that doing so really poses such
a threat. The experience of the Swiss, and soon
the Canadian, banking systems can be watched
closely for evidence of adverse effects.
RandallJ.Pozdena
Assistant Vice President
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board'of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author. ... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.
Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
@FedFRASER