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January 25,1974 T o w g u r d k U m iF r a r m l^ r Equivalent reserve requirements should apply to all deposits that effectively serve as a part of the public's money balances. That is the principle underlying the Federal Reserve proposal for the extension of the present system of reserve requirements to nonmember institu tions, to the extent that such institutions issue deposits that perform any type of checkingaccount function. Under the proposed legislation, the reserve-requirement range would be between 5 and 22 percent for demand deposits, with the specific figure determined, just as now, by the Federal Reserve Board of Governors. The range would be between 3 and 20 percent for NOW accounts, that is, interest-bearing deposits for which the depositor can make withdrawals by negotiable or transferable instrument. (Other time and savings deposits of nonmember institutions would not be covered.) The proposal would apply not only to banks, but also to savings and other depository institutions, along with foreign-owned banking institu tions that provide demand (or checking account) deposits. The reserves would be held in the form of vault cash or non-interest-earning deposits at the Fed. Easing the transition Uniform requirements could impose some burden on nonmember institutions, because even more of their assets than now could be re quired to be in non-interest-bearing form, thereby cutting into earnings. To offset this problem, the legislation includes a provision which effectively exempts the first $2 million of net demand deposits and NOW accounts from reserve requirements. In view of this provision, about 62 percent of present nonmember banks would be exempt from any reserve re quirements that exceed their present vault-cash holdings. This apparent exception to the basic principle of equivalent reserve requirements can be safely ignored, because the dollar amounts involved are relatively small and thus do not represent a problem for Federal Reserve control of the monetary aggregates. To ease the transition, required reserves would be phased in gradually over a four-year period, on those deposits (over $2 million) held at the time the law goes into effect. However, deposit increases above those existing at time of enactment would be immediately subject to the full reserve require ment. The legislation also would permit Federal Reserve credit to be made available to any institutions that maintain deposits with Reserve Banks, thus easing the rigid restrictions that now make non member borrowing difficult. This increased access to the Fed's discount window would provide a useful resource at times of strong pressures on institutions' liquidity positions. Liquidity— and policy Bankers have always recognized the need to hold some funds in liquid (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. form to honor deposit withdrawals promptly. Such reserves were usually held in the form of vault cash, deposits with central banks or other commercial banks, or short term government securities. To ensure maintenance of adequate liquidity, many nations have enacted banking legislation specifying minimum reserves to be held against deposits. In this country, prior to the founding of the Federal Reserve System, reserve requirements were imposed by national and state legislation as a means of protecting bank liquidity. The basic function of minimum reserve requirements, however, is not to ensure bank liquidity, but rather to permit the Federal Reserve to control the supply of money and credit in the pursuit of its important monetary-policy objectives. Reserve requirements can influence the growth of bank loans, investments and deposits, and thus are an important element in the monetarycontrol mechanism. The Federal Reserve controls the total amount of assets eligible to be used as legal reserves (through open-market operations) as well as the per centage of deposits that must be held as reserves, and thus can influence the key monetary aggre gates in accord with its basic policy goals. To permit proper central-bank management of the supply of money and credit, banking institu tions should meet their reserve requirements by holding assets in a form which is under the most direct control of the Federal Re serve. These assets could be either vault cash (Federal Reserve notes) or deposits at the Reserve Banks. This test cannot be met by present state legislation. Under such legislation, nonmember banks are not required to hold reserves in the form of deposits at Federal Reserve Banks, but may rather hold their reserves as correspondent balances with other commercial banks. When such reserves are held at a member bank, that bank naturally must sup port these balances with its own reserves consisting either of vault cash or cash at the Federal Reserve, but the size of its cash reserves will be only a fraction of the initial deposit at the nonmember bank. With present differential reserve requirements, therefore, shifts of deposits between member and non member banks alter the quantity of deposits at all commercial banks that can be supported by a given volume of bank reserves. This factor tends to loosen the links between bank reserves and the money supply, and weaken the Fed's con trol over the monetary aggregates. Combatting erosion The problem has been magnified by the substantial variability in the relative growth rates of member and nonmember banks. Over the past decade, nonmember banks have accounted for about 40 percent of the total increase in the volume of checking deposits, but the propor tions have varied widely from year to year. This variability has made it difficult to measure the impact of Federal Reserve actions on the monetary aggregates— and there fore on final policy objectives related to income, employment and prices. This may not have been a problem in 1945, when nonmember banks accounted for only 14 percent of all commercial-bank deposits, but it is a decided problem today, when the nonmember-bank share is 22 percent and rising. In effect, the System must use this monetary weapon quite sparingly, since an increase in required reserves would worsen the competi tive disadvantage of member banks and thereby threaten a further erosion of membership. Admittedly, reserve requirements were in creased during the 1973 boom, but their utilization as a major anti inflationary weapon may have been inhibited on other occasions by the considerations noted here. The growing importance of non member banks mainly reflects the competitive disadvantage imposed on member banks by requiring them to hold reserves in the form of vault cash or as deposits at the Federal Reserve. Nonmember banks, in contrast, can utilize required reserves as earning assets even when they are held as demand balances with other commercial banks, since these balances also serve as a form of payment for services rendered by city corres pondents. As a consequence, banks generally have an incentive to avoid membership in the Federal Reserve System. Since 1960, about 750 banks have left the System through withdrawal or mergers, and nearly 1,700 newly chartered state banks have remained outside, compared with just over 140 that elected System membership. Confronting NOW The erosion of membership in the System not only reduces the precision of monetary control, but it also reduces the potential for using changes in reserve requirements as an effective instrument of policy. Finally, the concept of equivalent reserve requirements gains new urgency because of the recent efforts of nonbank deposit institu tions to evolve new modes of money transfer. Mutual savings banks in Massachusetts and New Hampshire have begun to offer depositors a NOW account that closely resembles an interest bearing checking account. In California, savings-and-loan associa tions have sought direct access to an electronic money-transfer system operated by California banks, so that they could charge and credit the savings accounts of their customers in much the same way that checking accounts are handled at commercial banks. These initiatives offer obvious marketing advantages. However, they could affect monetary control adversely unless reserve require ments established by the Federal Reserve were applied to all deposit accounts involving money-transfer services. William Burke uoi8umseyv\ • qein • uoftejo • EpeAa|\| • oqepi 7 J |E 3 SSZ . B ! U J O p |B 3 • BUOZUy 0 3 S ID U E J J I U B S ON ilW tH d aivd 3DV1SO J s n HVW SSV1D 1SBIJ BANKING DATA— TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Loans adjusted and investments* Loans adjusted— total* Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) W eekly Averages of Daily Figures Member Bank Reserve Position Excess reserves Borrowings Net free (+ ) / Net borrowed (— ) Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases (+ ) / Net sales (— ) Transactions: U.S. securities dealers Net loans (+ ) / Net borrowings (— ) Amount Outstanding 1/9/74 Change from 1/2/74 79,461 60,615 1,475 20,951 18,310 9,146 6,039 12,807 75,077 22,831 735 50,330 17,737 22,733 7,261 10,619 770 716 35 — 168 + 10 + 7 — 98 + 44 1,063 — 158 — 564 + 222 — 22 + 298 + 68 + 94 Change from year ago Dollar Percent + 9,996 + 10,022 + 156 + 3,116 + 3,134 + 1,265 — 1,398 + 1,372 + 6,938 + 1,103 + 12 + 5,807 — 660 + 5,511 + 598 + 3,846 - + Week ended 1/9/74 - 30 79 49 Week ended 1/2/74 - 32 217 185 + + + + + + — + + + + + — + + + 14.39 19.81 11.83 17.47 20.65 16.05 18.80 12.00 10.18 5.08 1.66 13.04 3.59 32.00 8.97 58.36 Comparable year-ago period - 8 68 60 + 1,755 + 1,852 + 420 + + + 364 264 348 in c lu d e s items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, Digitized for FR&SERrancisco, California 94120. Phone (415) 397-1137. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis • E > |S E|V m NBMEH
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