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Michael A. Klein”
1.

fNTRODUCTfON

On June 16, 1933, President Roosevelt signed
into law the Banking Act of 1933, Section 11 of
which specified that “No bank shall, directly or indirectly, hy any device whatsoever, pay an interest
on any deposit which is payable on demand.” In
spite of the 45 years existence of the law, the concept of an “implicit” demand deposit interest rate
paid by banks to their depositors is used with increasing frequency by economists in a variety of
different c0ntexts.l
The determinants of the demand for money have
been one of the most intensively researched issues in
The well known IS-LM model of the
economics.
macroeconomics literature suggests a relationship between the effectiveness of monetary and fiscal policy
on the one hand and the nature of the demand for
money function on the other. Some recent work in
this area has attached central importance to the role
of the implicit deposit rate in the demand for money
function and, in the process, has significantly enhanced understanding of both the nature of this function and its implications for policy-making.
The use of the concept is by no means restricted
to money demand theory and its implications for
macroeconomic theory and policy. How efficient is
the U. S. payments system and to what extent is
that efficiency affected by the prohibition?
If the
prohibition were relaxed or removed entirely, what
would be the effect on bank costs and how would
this effect be transmitted to the banks’ depositors and
borrowers ? Would removing the prohibition lead
to a profound alteration of the competitive position of
banks vis&vis non-bank depository institutions such
as S&L’s and mutual savings banks?
It would be presumptuous
indeed to assert that
economists have arrived at anything like definitive
* The author, a member of the Department of Economics
at Indiana
University,
Federal
Reserve
Bank
of 1978.

was a Visiting
Scholar
at the
of Richmond
during the summer

1 The background
of this legislation as well as an appraisal
of some of the arguments
used to justify
the
prohibition
are discussed
in [3, Chapter 21.

answers to these questions.
But it is manifest that
the concept of an implicit deposit rate is an important ingredient in securing at least approximate
answers. The extent to which the spirit, if not the
letter, of the 1933 Banking Act has been circumvented by the payment of an implicit deposit rate
affects, in a s.gnificant way, economists’ responses to
the above questions.
The next section of this article examines several
approaches to the measurement of the implicit deposit rate. This is followed by a discussion of recent
research on the demand for money function-research
that makes extensive use of the implicit deposit rate
concept. Finally, some implications of the substitution of explicit for implicit interest payments are
examined.
The development of the NOW account
and the Federal Reserve Board’s recent proposal to
pay interest on member bank reserves are two dramatic examples of this substitution.
The article concludes with a discussion of some limitations of the
implicit deposit rate concept.
If.

MEASURES
DEMAND

OF THE
DEPOSfT

fMPf.fCfT
RATE

As administrators of the nation’s payments mechanism, commercial banks provide an important flow
of services to the general community.
The provision
of these payments services is costly both to the banking system and to society because real resources are
allocated to their production; resources that have an
economic opportunity cost measured by the value of
the other goods and services which we forego in
order to produce payments services. Yet the revenue
that a bank receives from these services is rarely
equal to the cost to a bank of providing them.
The explanation is well known: demand deposit
funds can be used to make loans and purchase other
interest-bearing assets the revenues from which are a
major source of commercial bank income. Competition for these funds cannot take the form of an
explicit interest rate and must, therefore, seek alternative outlets. Perhaps the most obvious alternative
is for a bank to reduce its charges to depositors for

FEDERAL RESERVE BANK OF RICHMOND

3

Table

I

BALANCES, INCOME, EXPENSES, AND
IMPLICIT INTEREST COST PER PERSONAL
CHECKING ACCOUNT, BY SIZE OF BANK
1975
Deposits
vp to $50M

$783.00

Average baiance
per account

Deposits
$50-200M

$967.00

Deposits
over S200M

$1,021.00

Income from service
and penalty charges
(per yeor)

14.80

11.28

14.56

Expenses

46.29

49.87

62.59

31.49

38.59

48.03

(per

year)

Implicit

interest

payment

Implicit

interest

rate

Implicit interest rate
adjusted for reserve
requirements

Source:

Federal

Reserve

4.02%

3.99%

4.70%

4.43%

4.49%

5.48%

Board

[3,

p. 221.

the use of bank payments services below the cost to
the bank of providing those services.
A recent study by the Federal Reserve Board
staff [3] attempted to quantify this dimension of the
implicit demand deposit rate using data from the
Federal Reserve’s Functional Cost Analysis ProThe program is designed to estimate the
gram.
costs and revenues associated with various bank
functions.
Table I summarizes the Board’s estimates for participating banks in 1975.
Implicit deposit rates were calculated by deducting
annual service charge income per account from expenses per account and dividing the remainder by the
average dollar balance per account. These estimates
appear in the next to last row. The final row adjusts
the interest rate for demand deposit reserve requirements. Since banks must hold non-interest-bearing
reserves equal to a minimum percentage of their
demand deposits, the cost to a bank for acquiring
funds available for Zending is correspondingly
increased.
It is important to understand that these calculations take account of only one easily quantifiable
method of circumventing the prohibition: the remission of service charges. In some circumstances such
calculations may significantly understate total implicit
For example, using the above
interest payments.
methodology the Board staff study calculated the
implicit deposit rate paid to conznzercial demand deposit customers.
The estimated rates after adjustment for reserve requirements were 1.60, 1.32, and
1.42 percent for the three size classifications of banks
4

ECONOMIC

REVIEW,

iisted in order of increasing size. The estimated
interest rates on commercial accounts were, therefore, oniy approximately
one-third of the rates on
personal accounts. Yet it is well known, and recognized by the Board study, that banks use devices
other than the remission of service charges to compensate business depositors. A wide variety of cash
management
services at subsidized rates is made
available by banks to business firms. In addition to
the provision of transactions services, depositor-borrowers may be given preferential lending treatment
in the form of reduced loan interest rates or superior
nonprice lending terms. These and other elements
of the complex relationship between a bank and its
depositors may be more difficult to quantify but are
not, for that reason, any less important than the:
more easiiy quantifiable remission of service charges.
The results of three different approaches to the
estimation of implicit interest rates are presented in
Table II. The first two columns provide time series
for the estimated demand deposit interest
rate
whereas the third column presents estimates of the
rate of interest on Mi, which includes currency as
well as demand deposits, for the 1960-68 period. The
reader will undoubtedly be struck by the differences
It is to be
in the magnitudes of these estimates.
remembered, however, that no comprehensive
data
source exists and very different
conceptual
approaches were used by the authors of the three
studies.
The rates shown in column 1, from William
Becker’s study [Z] , were derived by taking all noninterest expenses of a bank, subtracting
service

Table

II

ESTIMATED
DEMAND DEPOSIT INTEREST
(PERCENT) FROM THREE STUDIES
1960- 1968

RATES

Study
Year

W. Becker [2]
(1)

(2)

(3)

1960

2.64

1.72

2.38

1961

2.75

1.72

1.74

1962

2.89

1.72

1.94

1963

2.95

1.77

2.12

1964

2.98

1.80

2.40

1965

3.25

1.93

2.68

1966

3.32

2.12

3.46

1967

3.54

2.26

3.11

1968

3.74

2.42

3.70

Sarro-Santomero

[l]

8. Klein [131

Note:
Estimates reported in column 3 are weighted averages of
the interest rote on demand deposits and the assumed rero
rate of return on currency.

SEPTEMBER/OCTOBER

1978

charges, and dividing the difference by the level of
demand deposits. Federal Reserve data on the income and expenses of member banks were used and
since all non-interest bank expenses are attributed
to the demand deposit function, the series is almost
certainly biased upward to a significant extent.
In contrast, the Barro-Santomero
study [l] is
based on the authors’ own survey of 23 commercial
banks.
The figures presented are simply average
remission rates on personal accounts.
A remission
rate of $0.10 per month per $100, for example,
would be stated as an interest rate of 1.2 percent per
year.
Since remission of service charges based on
minimum balances is only one method by which
banks subsidize their depositors’ use of the payments
mechanism, actual implicit rates were undoubtedly
higher than those appearing in column 2.
Conceptually,
Benjamin Klein’s [ 131 estimates
(column 3) are the most interesting.
Rather than
basing an estimate of the deposit rate on revenue
and cost data, he attempts to estimate what rate of
interest banks would have paid on deposits had the
prohibition not been in force.
Put differently, he
attempts to estimate what the competitive, market
determined, demand deposit interest rate would have
been. He then assumes that the prohibition was, in
fact, completely ineffective and that, in one way or
another, the competitive rate was paid to depositors.
The nature of his results is described in more detail
in the following section of this article.
All three time series have a remarkable tendency
to move together: remarkable given the differences
in data and conceptual approaches.
The simple correlation coefficient between columns 1 and 2 is .97;
between columns 2 and 3 it is .93; and between
columns 1 and 3 it is .88. We may not know the
esact size of the implicit deposit rate, but we have a
pretty clear idea of the direction in which it is
moving !
111. SOME USES OF THE CONCEPT

money functions that exclude the rate of return on
demand deposits are used as benchmarks for comparison.
The most common form of the money demand
function appearing in these expositions is given by
the equation
(1)

Md/P

= f(r,Y)

where M” is the demand for nominal balances, P is
the price level, Md/P is the demand for real cash
balances, r is the rate of interest, and Y is the level of
real income. Although there exist substantial variations on the theme, virtually all empirical studies of
the determinants
of money demand include some
scale variable such as measured income, permanent
income, or wealth, and some measure of the opportunity cost of holding money such as the rate of interest on other liquid assets. The latter is included to
represent the sacrifice involved in holding money
rather than some other asset which, unlike money,
cannot be used directly to make payments but can be
easily converted into money should the need arise
and carries an explicit rate of return.
Of course, it
is anticipated that a rise in r will lower money demand-a
proposition which is repeatedly confirmed
by empirical studies.
Klein contends that the above specification of the
cost of holding money is likely to be seriously misleading. Since it identifies the cost of holding money
with the (usually short-term)
rate of interest, this
measure assumes that there is no pecuniary rate of
return, explicit or implicit, to the holding of money
balances. If, however, the prohibition of interest is
either partially or totally evaded, then this measure
will overstate the true cost of money holdings.
Klein has a second criticism, somewhat more involved, but helpful to an understanding of his empirical results. Consider the three assets listed below:
Asset
1. Money

The Implicit Deposit Rate and the Demand for
Money
One of the most interesting
recent
studies in which the concept of an implicit deposit
rate is given central importance is Benjamin Klein’s
analysis of the determinants
of the demand for
money [13]. The basic question he poses is this :
does the inclusion of a measure of the implicit deposit rate among the determinants of the demand for
money significantly improve economists’ ability to
explain the public’s money-holding
behavior over
long periods of time?
Conventional demand for

rm

2. Money Substitute

rs
i

3. Long-term Bond

OpP~mt&nity

RR”,‘t’,rif
i

- rm = Pm
i-

rs = Ps
0

The first asset is identified as money proper : literally
the medium of exchange.
It bears an interest rate,
denoted by rm, that can be explicit or implicit and
may or may not be equal to zero. The opportunity
cost of holding money is found by subtracting rm
from the rate of return on a second asset that yields
no monetary exchange services at all. This latter
asset is identified in row 3 and may be visualized as a

FEDERAL RESERVE BANK OF RICHMOND

5

long-term, non-marketable bond with rate of return i.
The difference i - r, is denoted by the symbol P,.
Klein refers to P, as the “rental price” of the exchange services provided by a dollar of money holdings.

Table

FORMS OF REGRESSIONS

A.

Form and Time Period of Regressions

(A)

log

M2

=

a0

(B)

log M2

=

a0

CC)

log

Ml

From the definitions
tionship exists :
(4)

P, -

P, =

r,)

-

(i -

r,) = r, -

rm.

If, as in conventional money demand analysis, the
implicit deposit rate is ignored, then rm = 0,
pm - Ps = rs, and equation 3 reduces to the conventional equation 1.
If this seems somewhat abstract, a simple example
may be helpful. Imagine it is hypothesized that the
demand for butter is a function of the price of butter
and the price of a close substitute such as margarine.
Equation 1 implicitly asserts that it is the differelzce
between the prices of butter and margarine that is
relevant whereas equation 2 is more general, stating
only that both prices are relevant but not imposing
any particular restriction on the nature of the dependence.
Finally, as indicated in the previous section, in
conducting his analysis Klein assumes that a competitive rate of interest was paid on deposits in spite
Rather than a direct calculation
of the prohibition.
of costs and revenues, the implicit deposit rate is
related to the rate of interest that banks could earn
6

al

log

Y +

02~

Y +

a2Ps +

aaPm

a0

+

al

log

03Pm

1.33

a0

-I- al log Y -I- azrs
(1919-1970)

Coefficient
Ps
.33

Estimates
Y

Pm

-0773
1.52

(B)
1.56

(Cl

.42

Source:

Adapted

from

estimates

Benjamin

.1207
-1254

1.31

All reported coefficient
confidence level.

- .06

-.45

(D)

Note:

rs

- .34

Standard1
Error of
Estimate

Klein

-.lO

are significant

.1493

at the 99

1131.

Ps,Y).

given above, the following rela-

(i -

Y

(A)

How is the usual specification of money demand
given by equation 1 related to the very general form
of equation 22 Klein points out that equation 1
implicitly assumes that it is the difference between
the rental prices of money and money substitutes
which determines the demand for money.
In this
case,
-

=

8.

= f(Pm,P*,Y>.

= f(P,

=

log MI

Equation

Md/P

+

a2Ps +

(1919-1970)
(D)

(3)

+ al log Y +
(1880-l 970)

(1880-1970)

Just as the demand for any commodity or service
is a function of its price, the price of close substitutes
and complements, and income, so the demand for
money can be written as:
Md/P

AND COEFFICIENT

ESTIMATES

The third asset (row 2) is defined as a money
substitute.
It yields exchange services-at
the very
least, it can be quickly and easily converted into
money at a very small cost-and
pays an explicit
rate of return denoted as rs. P, is its opportunity
cost and is referred to as the rental price for the
exchange services provided by the money substitute.

(2)

111

ECONOMIC

REVIEW,

on their marginal investments.2 After adjustment for
reserve requirements and other costs and subsidies
implicit in U. S. banking regulations, a deposit rate
series is constructed.
The rate of return on money
is then taken as a weighted average of the rates of
return on the components of the money stock.
On this basis, Klein compares regression results
for equations that have the general form of equation 2
above with the results for equations having the conventional form of equation 1. A summary of the:se
results is presented in Table III. Equations A and
C include the implicit rate of return on the holding
of money whereas equations B and D do not. Klein
shows that A and C have significantly smaller standard errors of estimate than do their counterparts.
In other words, the hypothesis that the prohibition
of interest payments on money has been completely
ineffective has more “explanatory power” than does
the alternative hypothesis that it has been completely
effective.

rd as the deposit rate, r1
return
on bank investment, and R/D
reserve to deposit ratio, then (assuming
interest)
the competitive
deposit
rate
rI(1 - R/D).
2 Designating

SEPTEMBER/OCTOBER

1978

as the marginal
as the marginal
reserves
earn no
would be rd =

AIso notice how similar are the coefficient estimates, except for sign, of P, and P, in equations A
and C. If, as is frequently alleged, P, - P, is an
appropriate measure of the cost of holding money
(recall that P, - P, is simply ry - r,), the estimated coefficients of P, and P, in equations A and C
should be identical except for sign. The actual difference between the coefficients is small enough to be
attributed to random error and, therefore, the hypothesis that rs - r, is an appropriate measure of
the cost of holding money cannot be rejected.
The
inclusion of a measure of the implicit rate of return
on money has enhanced the explanatory power of the
regression equations.
Therefore, Klein concludes
that the hypothesis that the prohibition of interest on
demand deposits has been effectiveIy enforced can be
rejected.
In addition to providing an imaginative approach
to the measurement
of the implicit deposit rate,
Klein’s work is important because it suggests that
regulatory policies affecting the payment of interest
on demand deposits may have significant zptacroecono&
implications.
When market interest rates
rise, there will be an associated increase in the impiicit return to holding money.
This results from
the increased competition among banks for deposit
funds.
Klein’s results imply that this rise in the
deposit rate will reduce the impact of a given rise
in the market interest rate on the demand for money.
Thus the observed change in the demand for money
is smaller than it would have been if deposit interest
prohibition had been effectively enforced.
Imagine that deposit interest prohibition is repealed and that an explicit, competitively determined
deposit interest rate replaces the implicit rate. Assume, as seems likely, that the explicit rate can be
adjusted more quickly and, perhaps, to a greater
degree in response to a change in market interest
rates than could the implicit deposit rate. It would
then follow that a change in the market interest rate
would induce a smaller change in the demand for
money than it does under present conditions.
The macroeconomic implications of this depend,
of course, on the particular macroeconomic model
used. In terms of the we11 known IS-LM model,
this reduction in the sensitivity of the demand for
money to the market interest rate would make the
LM curve more nearly vertical. This has the effect
of reducing the expansionary impact of a rise in
government spending financed by either taxes or the
issuance of bonds. At the same time, the impact of a
change in the money supply would be correspondingly increased.

D&aggregating
the Money Demand
Function
Benjamin Klein’s work reIates the rate of return on
money to the demand for money. But even the narrowest definition of the money stock commonly used
( M1) consists of currency held by the public as well
as demand deposits. Since an implicit return is paid
only on demand deposits, the question arises as to
how the demands for currency and demand deposits
individually respond to a change in the implicit deposit rate.
Although a number of studies of the public’s currency holding behavior exist, the only recent study
which makes the implicit demand deposit rate central
to both the theoretical and empirical analysis is that
of William Becker [Z], whose estimates of the implicit demand deposit rate were encountered in Section II. Becker relates the demands for currency
and demand deposits to the implicit demand deposit
rate as well as to the rates of interest on time deposits
and open-market assets. To represent the latter, the
4-6 month commercial paper rate was used.
He
found that although the demand for demand deposits
was sensitive to all three interest rates, currency
holdings were not significantly influenced by any
interest rate vzriable.
These findings tend to substantiate
a previous
study by Alan Hess [lo]. Hess did not include the
rates of return on time and demand deposits in his
currency demand function and measured the cost of
holding currency exclusively by the 4-6 month commercial paper rate. As did Becker, he found that
demand deposit holdings were sensitive to variations
in the rate of interest whereas currency holdings were
not.
In contrast, <neoretical models of household money
demand strongly suggest that a rise in the rate of
interest on demand deposits should lead to a fall in
desired currency holdings. For example, two recent
models treat the household’s decision problem as one
of financing a flow of expenditures over an interval
of time in a cost minimizing manner. In one model
[ 11, the household has a choice of three assets to
hold : currency, demand deposits, and liquid, interestbearing assets. In the other model [ 141, the asset
list is extended to include inventories of commodities.
In both models, the demand deposit interest rate
affects the optimal currency holdings of the household-a
rise in the former being associated with a
fall in the latter.
If theoretical analysis repeatedly indicates the importance of the demand deposit rate to the demand
for currency, why hasn’t this relationship been uncovered by the empirical analysis?
Utilizing a theoretical model of transactor behavior [ 141, it can be

FEDERAL RESERVE BANK OF RICHMOND

7

Table

OUTSTANDING

NOW ACCOUNT BALANCES IN MASSACHUSElTS
BY TYPE OF ISSUING INSTITUTION
(thousands

Commercial

Total
Month
Sept.
Dec.

Amount
--

Ended

11,094

1972
1972

IV

Amount
--

Percent

of dollars)
Mutual Savings
Banks
-

Banks
Percent

Amount
--

100

Savings and loans

Percent

11,094

-

Amount

-

Percent

100.0

44522

loo

44522

100.0

Dec. 1973

138,028

100

138,02B

100.0

Dec. 1974

286,819

100

56,989

19.9

200,083

69.8

29,747

10.4

Dec. 1975

742,516

100

302,029

4B.7

356,319

48.0

84,168

11.3

Dec.

1976

1,439#559

100

807,277

56.1

497,07 1

34.5

135,211

9.4

Nov.

1977

1,852,491

100

1,051,351

56.8

627,708

33.9

173,432

9.4

Jan.

1978

1,915,409

100

1,097#545

57.3

636,537

33.2

181,327

9.5

Note:

Sums may not add

Source:

Federal

to 100 due to rounding

Reserve Bank of Boston Statistical

errors.
Release.

shown that a rise in the implicit deposit rate (brought
about, for example, by a fall in service charges as a
‘result of a new entrant into a banking market) will
induce transactors to increase their average holdings
of demand deposits at the expense of both currency
and commodity inventories.
Thus, the magnitude of
the effect of a change in the deposit interest rate on
demand deposit holdings is expected to be substantially larger (and, of course, in the opposite direction) than its impact on currency holdings.
The discussion of Section II revealed that there
is no generally accepted method of measuring the
implicit deposit rate. It is possible that conceptual
difficulties in measurement reinforce the theoretical
implication that currency holdings are less sensitive
than are desired demand deposit holdings to variThis theme is
ations in the implicit deposit rate.
taken up again in the concluding section of the
article.
IV.

THE

SUBSTITUTION

IMPLICIT

PAYMENTS

OF EXPLICIT

FOR

ON DEPOSITS

Private Financial Innovation
The decade of the
1970’s has already witnessed profound changes in
the nature of the services offered by non-bank thrift
These changes have affected the cominstitutions.
petitive relationship between banks and thrift institutions and promise to generate an intensive and farreaching reexamination of the regulatory and structural environment
confronting
various classes of
Thrift institutions will aldepository institutions.
8

ECONOMIC

REVIEW,

most certainly continue their efforts to attract dfepositors by offering transactions
instruments that
bear explicit interest. In this context, the question (of
whether explicit interest payments should continue
to be prohibited on some transactions balances will
be under continuous reevaluation.
A financial history of this period will undoubtedly
cite the introduction of negotiable orders of withdrawal-NOW
accounts-as
the primary catalyst for
these changes. After a two year court battle, NOW
accounts were first offered by the Consumer Savings
Bank of Worcester,
Massachusetts,
on June 12,
1972.3 The NOW account is simply a method of
withdrawing funds from an interest-bearing
savings
account by means of a negotiable instrument payable
to third parties.
By the end of that year, 22 other mutual savings
banks in Massachusetts had adopted NOW accounts
and the development began to spread to New Hampshire where state laws governing savings banks are
similar to those of Massachusetts.
Commercial banks
were excluded from this development because Federal Reserve and FDIC regulations prohibited the
execution of third-party payments from savings :accounts.
Federal Reserve Board estimates of the
proportion of NOW balances attracted from commercial bank demand deposits suggest 80 percent
as a reasonable approximation
[ 161. Clearly, ,the
competitive position of banks in these states was
rapidly becoming untenable.
3 A good

survey

SEPTEMBER/OCTOBER

of these

1978

developments

is found

in [Ill.

The result was the passage of Public Law 93-100
on August 16, 1973, which permitted commercial
banks in these states to begin offering NOVCT accounts in January 1974. Table IV recounts the
growth of KOW accounts in Massachusetts and its
breakdown between depository institutions.
The pricing of NOW accounts is interesting both
in its own right and because it is at least indicative
,of pricing responses to be expected in a variety of
alternative contexts.
Although the maximum rate
of interest payable on NOW accounts is determined
by regulation rather than the market, the NOW
experiment is a vivid example of the substitution of
explicit interest payments for implicit payments on
transactions balances.
As of September 30, 1977, 112 commercial banks
were offering NOW accounts in Massachusetts.
Of
these, 108 were paying the maximum legal interest
rate of 5 percent although a wide variety of methods
of calculating interest and different frequencies of
compounding were used. Perhaps more interesting
is the diversity of approaches used in pricing transactions services.
Only 19 banks offered unlimited
free drafts ; 5 banks charged $10 per draft ; 7 charged
$15 per draft ; and 81 are classified as “other” by
the Boston Federal Reserve.*
This last category
includes banks using a combination of free drafts
plus a charge for each draft in excess of a specified
number.
Furthermore,
there is evidence [33 that
when the NOW experiment was extended to the
remaining New England states in March 1976, there
was a substantial drop in the percentage of institutions of all types offering unlimited free drafts. Thus,
the payment of explicit interest appears to have been
accompanied by the pricing of transactions services
more nearly in accordance with the private and social
cost of providing them.

the socially optimal quantity of money and will also
consider the correct opportunity cost of the resources
used in providing payments services in their decisions as to how intensively to use the bank payments
mechanism.
In contrast, the prohibition of explicit interest
payments provides the wrong signals to depositors.
The nonpayment of explicit interest induces households and business firms to economize on their holdings of cash balances when there is no social need to
do so. At the same time, implicit payments-such
as service charges set below the cost to a bank of
providing the services of the payments mechanismencourage excessive utilization of that mechanism.
There is, therefore, a resulting increase in the value
of society’s resources allocated to the provision of
payments services.
A second reason for the importance of NOW accounts is that these accounts can be issued-indeed
were initiated-by
non-bank financial intermediaries.
Thus a degree of functional specialization hitherto
existing between deposit-type institutions has been
significantly eroded.
Such specialization has historically been encouraged or required by regulatory
policy through limitations on asset acquisition and
liability issuance of different institutions.
Financial
innovation such as the NOW account may suggest
that the degree of regulatory-induced
specialization
is neither socially nor privately optimal.
Perhaps
more fundamentally,
competitive pressures toward
financial innovation in conjunction with advances in
payments technology may render it impossible to
maintain through regulation a non-interest-bearing
transactions instrument.
As a result, the traditional
demand deposit may have to adapt to changed circumstances or face extinction.5

A clear analysis of the efficiency implications of
the substitution of explicit for implicit pricing is
found in Harry Johnson [ 121. Johnson defines a
socially efficient monetary system as one in which
competition between banks forces the payment of a
competitive, explicit rate of return on the holding of
a stock of deposits. At the same time, banks charge
for their payments services in a competitive fa?hion;
that is, in a manner that reflects the private and social
costs of the resources allocated to the production of
those services. In this fashion, the public will hold

Finally, the implications of the substitution of
explicit for implicit payments deserve careful study
because the potential domain of applicability of this
structural change goes well beyond the XOW experiment itself. In late June 1978, the Federal Reserve Board made public a proposal for the payment
of interest on reserves combined with explicit pricing
of Federal Reserve services.
In other words, it
proposed a substitution of explicit for implicit pricing
in its relationship with its member banks.
The
following section examines the background to and
justification for the proposal.

4 The Statistical
Section of the Research
Department
of
the Federal
Reserve Bank of Boston publishes
data pertaining to NOW accounts in New England on a monthly
basis.
All NOW account
data used in this article are
from that source.

8 Evolution
is the likely alternative.
On May 1, 1978, the
Board of Governors
approved
a plan that will permit
individual
customers
of member banks to transfer
funds
automatically
from their savings
to their checking
accounts beginning
November
1, 1978.

FEDERAL RESERVE BANK

OF RICHMOND

9

The Federal Reserve’s Reform Proposal
Member banks of the Federal Reserve System are required to hold non-interest-bearing
deposits at the
Federal Reserve.
As a benefit of membership in
the System, banks are provided a variety of “correspondent” services by the Federal Reserve.
These
services include the clearing and collection of checks,
currency shipments, wire transfer of funds, security
safekeeping, and others. Although the Federal Reserve provides some services to nonmember banks,
these banks usually utilize the correspondent services
of other (generally larger) banks.
When one bank provides correspondent services to
another bank, the recipient (or respondent)
bank
“compensates”
the providing
(or correspondent)
bank by holding non-interest-bearing
demand balances with it in lieu of direct charges for the services
of the correspondent.
There is evidence that direct
user fees [7] are currently being assessed with
greater frequency than in the past for a variety of
But the general picture
correspondent
services.
remains: in exchange for a flow of correspondent
services, non-interest-bearing
deposits are held with
the providing bank.
Equivalently,
correspondent
banks pay an implicit return on the correspondent
balances they hold, just as banks in general pay an
implicit return to their demand depositors.
The Federal Reserve’s provision of services to its
member banks approximates,
at least in form, the
correspondent
arrangements
between private commercial banks. The Federal Reserve provides services to its members similar to those provided by
correspondent banks to their customers and member
banks hold non-interest-bearing
deposits at the Federal Reserve.
If this is so, why is the Federal Reserve proposing
a fundamental reform of the system?
The Board’s
proposal could be justified in terms of the efficiency
argument presented in the previous section of this
article. One important element of Professor Johnson’s thesis is that the Federal Reserve should pay
interest on reserves and charge for its services. The
nonpayment of interest on reserves is viewed as a
tax, the burden of which falls primarily on the deposit-holding public.
The Federal Reserve Board’s stated justification
for the reform is different.
The reform is designed
“to promote equality among member banks and other
financial institutions and to encourage membership
in the Federal Reserve System.” To understand the
problem that implicit pricing poses for the Federal
Reserve, a simple example may be helpful.
10

ECONOMIC

REVIEW,

Imagine there are two comparably sized nonmember banks, Bank A and Bank B, both served by a.
correspondent
bank, Bank C. Assume that their
demands for correspondent
services differ substantially. In particular, Bank A requires fewer checkclearing services than does Bank B. Bank C, the
correspondent bank, will require Bank B to pay for
the additiona check-clearing services by requiring
it to hoId a larger deposit balance than it requires
from Bank A. In this way, the private market can
flexibly adjust the costs of correspondent services to
the benefits received by the respondent bank.6
In contrast, the balance held by an individual member bank at the Federal Reserve bears no direct
relationship to the flow of Federal Reserve services
Instead, these balances are
received by the bank.
determined by reserve requirement ratios. A member bank that uses relatively few Federal Reserve
services cannot, for that reason, reduce its reserve
balance below that of another comparably sized mem:ber bank that utilizes these services intensively.
I:t
follows that the implicit rate of return on member
bank reserves varies directly with the utilization of
Federal Reserve services.
Member banks differ substantially in their utilization of Federal Reserve services. Two recent studies
are indicative.
In one [8], R. A. Gilbert surveye:d
233 member banks in the Eighth Federal Reserve
District.
Banks were ranked by size of assets and
divided into 11 groups of 20 banks each plus a remaining group consisting of the 13 largest banks in
the survey. The percentage of banks in the various
groups that cleared six or more checks through the
St. Louis Federal Reserve Bank during January
1977 ranged from zero in the second group (average
asset size of $7.2 million) to 92 percent in the largest
bank group (average asset size of $425 million).
Using a method similar to Becker’s procedure for
calculating the implicit return on deposits, Gilbert
estimates that the implicit return on reserves is approximately one-half of one percent for small banks
and 1.7 percent for the large banks surveyed.

s This argument
is subject to a qualification
imposed
by
the existence
of state reserve requirements.
If state reserve requirements
forced
nonmember
banks
to hold
correspondent
balances
in excess of those which would
be required
to compensate
the providing
bank for its
provision
of correspondent
services,
the adjustment
process described
above would be retarded.
However,
nonmember
banks appear to hold cash assets
significarrtly
in excess of the amount reauired
to satisfy state reserve
requirements
14, Appendix-A]
although
-one study [.9]
did find a relationshin
between the level of state reserve
requirements
and the amount
of cash assets
held by
nonmember
banks.
SEPTEMBER/OCTOBER

1978

Table V

NUMERICAL SUMMARY OF COMMERCIAL BANKS
BY MEMBERSHIP-SERVICE
USE COMBINATION
Fifth District States - January

1978

Deposit Size Groups
SO-2%
-I__-MU
MN
--

State
Maryland

2

$50.1 OOM

$2550M

AI\ Banks
$0.100M

MU
--

MN

MU
--

MN

MU
--

MN

7

5

5

3

14

24

16

North

Carolina

8

6

5

1

1

1

14

B

South

Carolina

8

8

4

1

1

0

13

9

20

68

16

30

5

6

41

104

9

57

7

20

9

5

25

155

39

57

21

15

107

227

on reserves

Instead, the Federal Reserve has proposed to substitute explicit for implicit pricing.
By paying an
explicit rate of return on reserves and charging for
Federal Reserve services, the link between a member
bank’s utilization of those services and the return
that bank receives on its deposits at the Federal
Reserve would be broken. Simultaneously, the cost
of the resources used in the provision of those services would be reflected in decisions concerning their
utilization.
As a result, the allocation of resources
would be improved.

82

47

quired to equalize the implicit return
among member banks.

Virginia
West

Virginia

Total

Note:
Source:

MU

=

Member

user; MN

Bruce J. Summers

=

Member

nonuser.

[17].

A study of the Fifth Federal Reserve District by
Bruce Summers [If] classified member banks as
users and nonusers of system services.
Basically,
member nonusers (MK) made no use whatever of
FederaI Reserve check clearing services whereas
banks classified as member users (MU)
cleared
checks “in volume’ through the Federal Reserve
Bank of Richmond and used two additional services
such as money transfer, security safekeeping, and
wire transfer of funds. His results for all member
banks up to $100 million in deposits are presented
in Table V.
The Federal Reserve could approach this problem
in a number of ways. For example, it could make
the reserve requirement ratio applicable to a bank
depend upon the degree of utilization of its services
by that bank. Banks that used those services intensively would be subject to correspondingly
higher
reserve requirement
ratios.
Although this would
approximate in form the arrangement existing in the
private correspondent
market, it seems impracticai
and difficult to implement.
A second possibility is to permit member banks to
use some fraction of their correspondent balances to
satisfy Federal Reserve reserve requirements.
To
some extent, this is already being done since the
required reserves of a bank are based on its net demand deposits.
In calculating its net demand deposits, a bank subtracts its balances at a correspondent
from its total demand deposits.
This is
equivalent to using a fraction of its correspondent
balances to satisfy the reserve requirement.
But the
current “offset” is much smaller than would be re-

V.

SUMMARY

AND CONCLUSIONS

Although the implicit deposit rate concept can be
productively used in a variety of applications, it is
subject to certain limitations.
It conceals information and, to some extent, provides false information.
The statement that an explicit rate of return of 5
percent per annum is paid on deposits has a clear,
unambiguous meaning : the deposit of an additional
dollar will generate a marginal pecuniary return to
its holder of 5 cents per annum-a
return which is
explicit and not dependent on the characteristics of
the individual depositor.
No such information is provided by the assertion
that the implicit deposit rate is 5 percent.
Indeed,
no direct marginal pecuniary or nonpecuniary return
may be involved at all. Unless the additional deposit
enables the depositor to avail himself of additional
bank services at subsidized rates, the marginal return
is zero no matter what the average return is calculated to be.
Moreover, any calculated average implicit return
can conceal enormous differences between the rates
paid to different depositors.
Depositors who make
relatively heavy use of subsidized services receive a
correspondingly
higher implicit return unless minimum required deposit levels are continuously adjusted for the level of utilization of bank services.
The fact that the implicit deposit rate is not a
direct market signal restricts its usefulness for analytical purposes. For example, a rise in bank costs
of providing payments services will inflate the estimates of the implicit deposit rate as constructed by
Becker or Gilbert and yet private decision-makers
would not alter their behavior unless the rise in costs
is translated into a change in a market price such as
the service charge rate. Thus, the implicit deposit
rate can change with no effect on behavior and conversely. In response to these analytica difficulties, a

FEDERAL RESERVE BANK OF RICHMOND

11

recent study of household demand for checking account money by John Boyd [5] made no attempt
whatever to define a single interest rate as the rate
of return on demand deposits.
Instead, household
behavior was related directly to the monthly service
charge rate and the minimum balance requirements
imposed by banks.
In this article, several methods of measuring the
implicit deposit rate have been examined.
The use
of the concept in recent research on the demand for
money has been explored.
In the process, it was
shown that a link exists between the form and effec-

tiveness

of price regulation in the financial markets,
and the behavior of the macroeconomy.
Finally, two
examples of the substitution of explicit for implicit
pricing were discussed: the evolution of the NOMi
account and the Federal Reserve Board’s proposa:l
for the payment of interest on reserves.
There is a
strong presumption in economic theory in favor of
explicit pricing.
This presumption applies to the
relationship between a commercial bank and its depositors. It applies with equal force to the relationship between the Federal Reserve and its member
banks.

References
1. Barr-o, R. J., and Santomero, A. M. “Household
Money Holdings and the Demand Deposit Rate.”
Journal of Money,
Credit and Banking,
(May
1972), pp. 397-413.

10.

Hess, Alan C.
“An Explanation
of Short-Run
Fluctuations in the Ratio of Currency to Demancd
Deposits.,, Journal of Money, Credit and Banking,
(August 1971)) pp. 669-678.

2. Becker, Willian E. “Determinants
of the United
States Currency-Demand
Deposit Ratio.”
Journal
of Finance, (March 1975)) pp. 57-74.

11.

Hoffman,
C., and Herman, E.
“NOW Accounts
in New England.”
Studies on the Payment of
Interest on Checking Accounts.
Washington, D. C. :
American Bankers Association,
1976, pp. 23-38.

3. Board of Governors of the Federal Reserve System.
“The Impact of the Payment of Interest on Demand Deposits.”
Staff Study, 1977.
4.

Board of Governors of the Federal Reserve System.
“The Burden of Federal
Reserve Membership,
NOW Accounts, and the Payment of Interest on
Reserves.”
Staff Study, June 1977.

5. Boyd, John H. “Household Demand for Checking
Account Money.” Journal of Monetary Economics,
(April 1976), pp. 81-98.

in Monetary
12. Johnson, Harry G. “Efficiency
agement.”
Journal of Political Economy,
tember 1968)) pp. 971-991.

Man(Sep-

13. Klein, Benjamin J.
“Competitive
Interest Payments on Bank Deposits and the Long-Run Demand
for Money.”
American
Economic Review,
(December 1974)) pp. 931-949.
14.

6. Cagan,
Phillip.
Determinants
and Effects
of
Changes in the Stock of Money 187'5-1960,
New
York:
National
Bureau of Economic Research,
1975.

Klein, Michael A.
“Deposit Interest Prohibition,
Transactions
Costs, and Payments
Patterns:
A
Theoretical
Analysis.”
Metroeconomica,
26, p:p.
144-152.

15.

7. Clark, John S. “New Study Shows Where Correspondent Banking Stands, Where It’s Headed.”
Banking, (November 1976).

Knight,
Robert
E.
“Comparative
Burdens
of
Federal Reserve Member and Nonmember Banks.”
Monthly Review, Federal Reserve Bank of Kansas
City, (March 1977)) pp. 13-28.

16.

Paulus, John D. “Effects
of ‘NOW’ Accounts on
Costs and Earnings of Commercial Banks in 197,41975.” Staff Economic Studies No. 88. Washington: Board of Governors of the Federal Reserve
System, 1976.

17.

Summers, Bruce J.
“Required
Reserves,. Correspondent Balances and Cash Asset PosItIons <of
Member and Nonmember
Banks: Evidence from
the Fifth Federal
Reserve District.”
Federal
Reserve Bank of Richmond, Working Paper 78-,3,
April 1978.

8. Gilbert, R. A.
“Utilization
of Federal Reserve
Bank Services by Member Banks: Implications for
the Costs and Benefits of Membership.”
Review,
Federal Reserve Bank of St. Louis, (August 1977),
pp. 2-15.
9. Goldberg, L. G., and Rose, J. T. “Do State Reserve
Requirements Matter. ?” Journal of Bank Research,
(Spring 1977)) pp, 31-39.

12

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1978

EY
Address
HENRY
Member,

by

C. WALLKH

Board of Governors

of the Federal

at the M.B.A. Graduation Exercises
Fordham

Reserve

System

of the

Graduate School of Business, New York, New York
June 28,1978

As you prepare to arise from this seat of learning, the years of intake end and the moment of output is at hand. You may well suspect that you will
never know so much as you do now. For a while,
you may feel like those great minds who forget more
in a year than some learn in a lifetime. Education,
after all, is what remains when all the detail has
been forgotten.
And if you find yourselves close to
some leader of business or government, you may be
Nothing is imcontributing to great achievement.
possible to the man with a competent assistant.
At this time, you are presumably looking at your
future role in the world in the broadest possible
sense, including a moral sense. Today I would like
to talk to you about one aspect of your future that
has a moral dimension, although it is technically an
f mean the breakdown in our
economic problem.
standards of measuring economic values, as a conNothing that is stated about
sequence of inflation.
dollars and cents any longer means what it says.
Inflation is like a country where nobody speaks the
truth.
Our failure to deal effectively with inflation
results largely from our failure to regard it as a
moral issue.
Inflation as Deceit
Inflation introduces
an element of deceit into most of our economic dealings.
Everybody makes contracts knowing perfectly well
that they will not be kept in terms of constant values.
Everybody expects the value of the dollar to change
over the period of a contract.
But any specific allowance made for inflation in such a contract is
bound to be a speculation.
We do not know whether
the most valuable part of the contract may not turn
out to be the paper it is written on. This condition
is hard to reconcile with simple honesty.
If our contracts were made in terms of unpredictably shifting measures of weight, time, or space,
as we buy food, sell our labor, or acquire real estate,

we would probably regard that as cheating, and as
intolerable.
Yet the case is much the same when
we are dealing with monetary values.
Nor are we dealing with small differences between
promise and performance.
At the going rate of inflation of about 8 percent, a year at a leading college
that today costs $7,000 will cost $32,630 by the time
your children approach college age. If you buy an
average home, by the time your present iife expectancy ends, your heirs could sell it for almost $2.5
million. Of course, the only sure thing about these
calculations is that they will not materialize.
Inflation is not stable, nor is it predictable. But I hope
the illustrations make their point.
The moral issues posed by inflation go beyond
what I consider deceit. Inflation is a means by which
the strong can more effectively exploit the weak.
The strategically positioned and well organized will
gain at the expense of the unorganized and the aged.
Because inflation itself is unpredictable, its effects
also cannot be predicted and safeguarded against.
Inflation is a means by which debtors exploit
creditors.
The interest rate may contain an inflation premium, but when you consider that it is
taxable to the creditor and tax deductible to the
debtor, the scales obviously are ill-balanced.
The
small saver, moreover, by law is not even allowed
to obtain an adequate inflation premium.
Interest
rate ceilings on savings deposits see to it that he will
be a sufferer from inflation.
The unpredictability
of inflation, again, makes any inflation premium a
speculation.
In the eyes of economists and of government, inflation becomes a means of exploiting labor’s “money
illusion,” i.e., its supposed failure$ to anticipate inThe device through which this
flation correctly.
mechanism operates is the well known “Phillips
Curve,” i.e., the alleged tradeoff between unemployment and inflation, It is believed that labor will re-

FEDERAL RESERVE BANK OF RICHMOND

13

spond to a seemingly large wage offer that subsequently is eroded by inflation.
If labor fails to
notice the trick, it will keep working for less than
it really had demanded, and employment will be
higher. A government pretending to serve a nation’s
interest by, say, misinforming the people about its
military plans would be harshly taken to task. Why
should trading on the people’s money illusion be regarded any differently ?
As it happens, the attempt to trade on money illusion has backfired because labor turned out not to
be money blind. Mounting inflation was increasingly perceived and as it came to be perceived, to
accelerate.
In consequence, we got both high inflation and high unemployment.
Deceit revealed and
rejected nevertheless remains deceit.
Business accounting is made deceptive by inflation.
Inventory profits, and profits due to a depreciation
schedule that does not take adequate account of replacement costs, grossly exaggerate true earnings.
The government permits a remedy for the former
-through
LIFO-but
not for the latter.
The effects on profits of a firm’s net debtor or creditor position are ignored.
Taxes and dividends are paid
from profits that may not exist or, if they can be
shown to exist by appropriate
accounting adjustments, are not backed up by cash flows. In addition
to misleading the stockholder and the public, these
conditions push firms into higher leveraging.
Business thus becomes more speculative.
Meanwhile, planning ahead becomes more difficult
for business.
Investment lags because long-term
commitments involve risks that inflation makes incalculable.
The need to guard against these unknowable risks compels both parties to any transaction-buyer
and seller, empIoyer and employee,
lender and borrower--to
introduce a risk premium
into pricing.
Each must demand a little more or
offer a little less than he would under noninflationary
conditions.
That reduces the range of possible
bargains and the level of economic activity.
Fewer
jobs and less output in the private sector are the
results.
Inflation also undermines the honesty of our public
policies. It allows the politician to make promises
that cannot be met in real terms, because as the government overspends trying to keep those promises,
the value of the benefits it delivers shrinks. A permissive attitude toward inflation, by allowing the
government to validate its promises by money creation, encourages deceitful promises in politics.
14

ECONOMIC

REVIEW,

Inflation
Threatens
the Market
System,
Property, and Democracy
Finally, inflation becomes
a means of promoting changes in our economic,
social, and political institutions that circumvent the
democratic process.
Such changes could be forced
upon a reluctant nation because inflation may end up
making the existing system unviable. One instance
is the diminishing ability of households to provide
privately for their future.
Personal savings, insurance, and pension funds all become inadequate.
Money set aside in any of these forms for old age,
for sickness, or for education could be wiped out by
accelerating inflation.
One may indeed ask whether
it is not an essential attribute of a civilized society
to be able to make that kind of provision for the
future.
But that is not the point I want to stress.
Rather, I want to emphasize that the increasing un-.
certainty in providing privately for the future pushes
people who are seeking security toward the government.
Today, the best hedge against inflation is to be
retired from the Federal Government.
That guarantees a reliably indexed pension which may outgrow
the pay of the job itself. Social security is the next
best thing, although at a much lower level. Every
other form of pension, even if indexed, is exposed to
the risk that the employer, or the private sector a:5
a whole, may not be able to perform. A government
pension is riskless, short of a strike at the Bureau of
Engraving and Printing.
A similar trend toward bigger government threatens at the level of productive enterprise.
Inflation.,
as I have noted, distorts corporate accounting and
cash flows. It creates liquidity and profitability problems. Strong firms become less strong, less strong
Dependence
upon and
firms become marginal.
eventually absorption by government may be the ultimate outcome. Countries like Italy and Great Britai,n
are already on their way to this solution.
In the United States we have not yet reached tha.t
condition, although the increasing passage of the raillroads into government hands is a danger signal. But
the role of government nevertheless has expanded as
the private sector has retreated before the impact of
inflation.
Mounting regulation, tax burdens, and
other impediments, of course, have also contributed
their part.
Not long ago it was taken for granted that at fu’ll
employment the private sector should be strong
enough to produce a surplus in the Federal budget.
It was expected, in other words, that the inherent
impulses of private consumption and especially in-

SEPTEMBER/OCTOBER

1978

vestment would generate a level of aggregate demand
sufficient to absorb capacity output, Today this has
become very doubtful. Capital formation is too weak
and consumption too low to generate enough demand
to sustain the economy
at full employment without
the crutches of a Federal deficit.
We might be able to change this by appropriate
tax reform that would stimulate investment.
We
could adopt policies that would cut down our enormous trade deficit that is sucking purchasing power
out of the country.
But inflation is an obstacle on
Tax reform is unlikely to
either of these courses.
call forth large-scale business investment so long as
inflation beclouds the outlook.
Policies to improve
the trade balance will avail little if inflation reduces
our competitiveness.
Thus, by one route or another, inflation creates a
vacuum in the private sector into which the government moves. By making the performance of the economy inadequate, inflation is likely to induce expanded
government activity.
The same result may follow
if inflation leads to the imposition of wage and price
controls. Indeed, if enduring controls were imposed,
which I do not expect, our market economy would
be on the way out. Of the three great dimensions
of our society-private
rather than public ownership,
decision-making by the market rather than by central
planning, and democracy rather than authoritarianism-private
ownership and market decision-making
No one can say how long,
will then be in retreat.
under such conditions, a shift also in the third dimension, away from democracy and toward authoritarianism, can be avoided.
The Sources of Inflation
What can be done?
Before we look for remedies, we must examine the
causes.
Inflation is like cancer-many
substances
are carcinogenic, and many activities generate inflation. The sources of inflation can be diagnosed at
several levels. The familiar debate about the sources
Do guns kill
of violence provides an analogy.
people?
Do people kill people ? Does society kill
people ? Some assert that money, and nothing but
money, causes inflation-the
“guns kill people”
proposition.
Some assert that the entire gamut of
government policies, from deficit spending to protectionism to minimum wage to farm price supports to environmental and safety regulations, causes
inflation-the
“people kill people” proposition. Some
argue, finally, that it is social pressures, competition
for the national product, a revolution of aspirations,
which are at the root-the
“society kills people”
proposition.
The first view holds the central bank

primarily responsible for inflation, the second the
government in general, the third the people that elect
and instruct the government.
In addition, time preference, i.e., the social discount rate, enters into the equation.
Inflation usually is the final link in a chain of well-meant actions.
The benefits of a tax cut, or of increased public
spending, are felt within a few weeks or quarters.
The penalty in terms of inflation, however, may not
come until after a couple of years or even later.
Inflation is the long-run consequence of short-run
expediencies.
Liie, to be sure, is a succession of
short runs, but every moment is also the long run of
some short-run expediency of long ago. We are now
experiencing the long-run consequences of the shortrun policies of the past. These consequences are as
unacceptable as rain on weekends, and just as easy
to change. If we continue to meet current problems
with new short-run
devices, the bill will keep
mounting.
We will not defeat inflation if we always take the
short view. We will then always find that the cost
of fighting inflation is always too high, the shortrun loss of output and employment too great. We
shall find ourselves ignoring inflation, in the hope
that it will somehow not grow worse. That is pure
self-deception.
Cancer ignored does not become
stationary, and neither does inflation.
Inflation
ignored accelerates.
A Plan for Action
A long view is needed on
inflation.
It is a view very different from that of
the politician, who is under enormous pressure to do
quickly something that looks good. Harold Wilson
said that in politics one week was a long time. More
charitably, the pressure is until the next election. If
the people will not instruct their elected representatives to do the things that are needed to end inflation,
if they turn them out of office because the remedies
take time and are temporarily painful, we will keep
getting a little more employment and output now
at the expense of much more unemployment and loss
of output later.
And we will get more inflation
all along the way, down to its ultimate consequences.
We need to make the ending of inflation our first
priority.
That must be our overall policy. To implement it in the current circumstances, we need to
take a number of steps, some of which I shall list
here.
1. We need to recognize that we are currently
very close to full employment and accordingly must
slow down the growth of the economy, gradually but
firmly, to its long-term rate of 3%-3% percent.

FEDERAL RESERVE BANK OF RICHMOND

15

2. We must limit the pending tax cut to what is
needed to offset the effect of inflation on income
brackets, perhaps of the order of $10 bilhon.
3. We must work to bring the budget deficit for
1980 below $40 billion.
4. Monetary
policy must prevent increases in
money growth that would fuel inflation and must
gradually bring the growth of the monetary aggregates down to levels commensurate with the real
growth rate of the economy.
5. We must stop addin g to inflation by government action such as protectionism, regulation, farm
price supports, minimum wage increases, and high
government construction costs.
6. We must promote competition through antitrust action, and productivity through tax changes
that stimulate investment.
7. We must maintain as strong a dollar internationally as our balance of payments will permit.
8. We would be wise to adopt an incomes policy,
commonly referred to as TIP, that employs the tax
system and the market mechanism, free from the
taint of wage and price controls.

16

ECONOMIC

REVIEW,

The President’s program of voluntary de-escaIation of price and wage increases deserves everybody’s,
support, But in our highly competitive environment,
voluntary sacrifices on the part of labor and business,
have their limitations. We should view the program
as a supplement to, not a substitute for, a comprehensive anti-inflation program.
If inflation is a moral problem, we require a moral
solution ; that is, ( 1) a recognition that public policies have led to serious inequities affecting people in
different and unequal ways and (2) a commitment
to new policies that will correct the cumulative distortions and contribute to desired economic progress.
The policies I have proposed require taking a longrun view of inflation.
Nothing will stop inflation
overnight, and in the short run the gains will always
seem dearly won. But without such a long-run approach, the damage will mount and the ultimate costs
will escalate.
You, as you assume your roles in the productive
sector of our nation, are in a better position than
You have
anyone to take such a long-run view.
nothing to gain from the expedients of the past.
You have a lifetime interest in the honest, non-inflationary, productive
performance
of the American
economy.

SEPTEMBER/OCTOBER

1978

MANAGING

CASH ASSETS: OPERATING

BALANCES AND RESERVE REQUIREMENTS
Bruce J. Summers

Nonearning cash assets make up a significant part
of commercial bank balance sheets and have an important influence on bank income. This category of
asset yields no monetary return, but must be matched
by liabilities on which interest, either implicit or
explicit, is paid.
However, cash assets do yield
implicit returns in the form of services that are
necessary to the normal course of commercial banking. Effective commercial bank cash management
requires that sufficient nonearning cash assets be
held to meet normal business requirements and that
excess cash balances be minimized. This is a necessary condition if the return on assets is to be maximized.
The factors that determine bank holdings of cash
assets can be classified into two broad categories:
(1) operational factors and (2) legal factors.
The
former consist primarily of liquidity needs and bank
demands for correspondent services. The latter consist of state and Federal reserve requirements that
are administered by the various bank regulatory authorities.
While the cash requirements determined
by operating needs can reasonably be thought to be
constant among banks of like character and location,
reserve requirements
vary depending on Federal
Reserve membership status.
In discussions of the
cost of Federal Reserve membership, the differing
impact of Federal Reserve and state reserve requirements on bank nonearning cash positions is a key
issue.
This article examines the influence of operating
requirements and reserve requirements on Fifth District member and nonmember banks of less than $100
million in asset size.’
The first section describes
how operational and legal factors combine to determine bank cash asset positions. The second section
reviews Fifth District state and Federal Reserve
System reserve requirements and critically examines
1 These banks account
for over
District
banks and approximately
commercial
bank deposits.
On
less than $100 million in asset
three-quarters
of all banks and
commercial
bank deposits.

90 percent
of all Fifth
30 percent
of total
a national
basis, banks
size account
for about
over 20 percent
of total

the popular approach to explaining differences in
member and nonmember bank holdings of cash assets.
In the third section, the influence of reserve requirements on actual bank cash asset positions is examined.
The main conclusions of the article are
summarized in the fourth section.
Factors
Determining
Nonearning
Cash Asset
Positions
Banks hold a variety of cash assets,
which fall into six categories for official reporting
purposes. Schedule C of the Consolidated Report of
Condition lists these six categories as:
1. Cash items in the process of collection ;
2. Demand
States ;

balances

with banks

in the United

3. Other balances with banks in the United States,
including interest-bearing
balances ;
4. Balances with banks in foreign
cluding interest-bearing
balances ;
5. Currency

countries,

in-

and coin;

6. Deposits with the Federal Reserve.
Time balances held with U. S. banks may earn
interest, and therefore do not strictly belong with
nonearning cash assets. Except for large banks, balances with foreign banks do not generally play an
important role in determining total cash positions,
and can be ignored in analyses focusing on smaller
sized banks. This leaves cash items in the process of
collection (CIPC),
demand balances due from domestic banks, currency and coin or vault cash, and
deposits with the Federal Reserve as the major components of smaller bank nonearning cash portfolios.
Opportunity Cost and Implicit Return
The cost
associated with holding these nonearning cash assets
is an opportunity cost equal to the income foregone
by not investing the funds. This opportunity cost
is equal to the cost of supporting matching liabilities,
including interest payments and operating expenses,
plus a profit margin.

FEDERAL RESERVE RANK OF RICHMOND

17

The return associated with holding these assets is
return, i.e., the rate of return is not
expressed as a monetary interest rate. Rather, the
return takes the form of service yields to the bank.
Nonearning
cash assets provide essentially three
types of services : ( 1) they provide banks with liquidity ; (2) they gain banks access to certain correspondent services ; and (3) they meet banks’ needs
for legal reserve assets.
an implicit

Binding Versus Nonbinding
-Reserve Requireptzents A commonly held view is that the proportion
of cash assets to total assets held by banks is determined primarily by reserve requirements.
If reserve
requirements force banks to maintain a proportion of
cash assets greater than that which would be maintained purely for operating purposes, then reserve
requirements are defined as binding. It is also possible, however, that the proportion of cash assets held
by banks for purely operating purposes may exceed
the minimum proportion held in response to the legal
requirement.
In this case, reserve requirements are
defined as nonbinding.
Whether or not reserve requirements are binding
or nonbinding is important for at least two reasons.
First, reserve requirements
are always incIuded
among the tools of monetary policy. If these requirements are lowered (raised), economic theory states
that a multiple expansion
(contraction)
of bank
credit and deposits is to be expected.
Clearly, however, this theory holds only if reserve requirements
are binding. For example, given a reduction in reserve requirements, banks would reduce cash assets
and thereby increase bank credit only if the amount
of such assets held to meet the legal reserve requirement was greater than the amount held to fulfilI
operating needs. Second, the effects of reserve requirements on member and nonmember banks have
implications for the question of the comparative costs
of membership versus nonmembership in the Federal
The cost of membership is equal
Reserve System.
to the income foregone on cash assets maintained
for the purpose of meeting System reserve requirements that are in excess of operating needs. By contrast, the cost of nonmembership
is equal to the
income foregone on cash assets maintained for the
purpose of meeting state reserve requirements that
are in excess of operating needs. If state and Federal
reserve requirements are binding, changes in these
requirements
would lead to changes in bank cash
positions that might alter the relation between the
opportunity costs associated with membership versus
nonmembership.
If both are nonbinding, reserve
requirements would not be relevant to the question
18

ECONOMIC

RBVIEW,

of the comparative costs of System membership
the nonmembership alternative.

and

Explaining Cash Assets of Nonmember
and Member Banks Each of the four main types of cash assets
described above provides some combination of liquidity, correspondent service, and legal reserve service
to commercial banks. A hypothetical example wi1.1
help illustrate how cash items in process, due from
balances, vault cash, and deposits with the Federal
Reserve combine to meet these various needs for
nonmember and member banks.
Assume there are two commercial banks identical
with respect to size, location, and deposit composition, but not Federal Reserve membership status.
With all their characteristics identical except membership status, these ideally paired comparison banks
can also be assumed to have identical demands for
correspondent banking services. For simplicity, also
assume that these banks do not act as correspondent
banks, i.e., they do not provide correspondent banking services to respondent banks. This assumption
is realistic for smaller banks only, and even then
may not be true in every instance.
The nonmember bank holds three of the four types
of cash assets described above, and its holdings of
each asset can be expressed as a percentage of total
deposits.
Let c,, be the total nonearning cash asset
to total deposit ratio of the nonmember bank, where
the subscript n denotes nonmember.
Then
GJ = pn + b, A- vn,
where p, b, and v represent proportions
to total
deposits of cash items in process of collection, due
from balances, and vault cash, respectively.
Using
the same notation but with the subscript m to denote
the member bank, we have
cm =

pm

+

br,

f

vm +

fm,

where f represents the proportion to total deposits of
balances held with the Federal Reserve. How then,
do operational and legal factors combine to govern
the proportions of cash assets to total deposits held
by nonmember and member banks?
The contribution made to bank operations by each type of cash
asset will be described below, followed by an explanation of the interaction between operational and
legal factors for the comparison nonmember
and
member banks.
For both the nonmember bank and the member
bank, cash items in process of collection represent
uncollected funds arising primarily in connection with
check clearing activity.
The proportion of CIE’C
held is determined by the dollar volume of checks
SEPTEMBER/OCTOBER

1978

being presented for clearing and by the clearing
bank’s (i.e., a Reserve bank or private correspondent
bank) collection schedule. The clearing bank’s collection schedule and accounting procedures also influence due from balances, for once collected, funds
are credited to the respondent’s correspondent
account.2 For simplicity, assume that dollar volume of
clearings is the dominant factor underlying the proportion of CIPC held. Given their identical characteristics, it can reasonably be assumed that the
average volume of clearings is identical for the two
Their proportions of CIPC to
comparison banks.
total deposits, therefore, are also identical.
Each of the comparison banks must hold liquid
assets for the purpose of meeting anticipated and
unforeseen deposit withdrawals. Deposit withdrawals
may be made in the form of check or cash. For the
nonmember bank, due from balances and vault cash
both provide such liquidity services.
The member
bank liquidity requirement, which is assumed equal
to that of the comparison nonmember bank, is met
using due from balances, vault cash, and deposits
held with Reserve banks.
Vault cash, moreover,
must be held in some minimum amount that allows
the banks to meet that part of the liquidity requirement associated with currency demands. The other
types of cash assets available to meet liquidity requirements will supplement the minimum proportion
of vault cash that is determined by currency needs.
A primary means of payment for correspondent
banking services involves holding balances with correspondents
[4], and therefore due from balances
carry an additional service yield in the form of correspondent services. The nonmember bank receives
all of its correspondent banking services from private
correspondent
banks, while the member bank can
satisfy at least part of its correspondent service requirement using System services. Recalling that the
total correspondent
service requirement is assumed
equal for the two comparison banks, it follows that
the member bank’s holdings of due from balances will
be less than those of the nonmember bank. This is
the case inasmuch as balances held with correspond2 Correspondent
bank accounting
procedures
make
it
difficult
to clearlv distinguish
between
CIPC and due
from balances for-banks
clearing through correspondents.
Some correspondent
banks grant immediate
book credit
for cash items oresented
for clearing. a nractice that acts
to understatedespondent
bank CIFC and to overstate
due from balances.
Federal
Reserve banks grant book
credit for cash items according
to a oredetecmined
collection
schedule
based on actual
clearing
experience.
Consequently,
CIPC may be lower, and due from balances higher, for banks clearing through
correspondents
For
than for banks clearing
through
Reserve
banks.
simplicity,
due from baiances
as used in this section of
the article represent
collected funds.

ents vary depending on the amount of private correspondent services consumed. The greater the share
of the member bank’s total correspondent
service
needs that is satisfied through the Federal Reserve
System, the smaller its holdings of correspondent
balances relative to those of the nonmember bank.
Both due from balances and vault cash are eligible
reserve assets for the nonmember bank. Some states,
moreover, count CIPC as eligible reserve assets.3 If
the legally required minimum combination of due
from balances, vault cash, and, where appropriate,
CIPC exceeds the minimum needed for purposes of
liquidity and gaining access to correspondent
services, then the state reserve requirement is binding.
If the proportion of cash assets required for legal
purposes is less than or equal to the desired operating minimum, then the state reserve requirement is
nonbinding.
In practice, it may be difficult to clearly identify
cases of binding state reserve requirements.
If required cash assets exceed desired cash assets, what is
actually observed is that amount of cash assets held
to meet the requirement;
this is a necessary legal
condition for the bank to continue operating.
In
this case it is impossible to tell whether the reserve
requirement is nonbinding (required cash just equaling desired cash) or whether the requirement
is
binding (desired cash being less than required cash).
However, if actual observed cash assets exceed the
calculated minimum of required cash assets by a
substantial margin, the unambiguous conclusion is
reached that reserve requirements are nonbinding.
In this case observed cash equals desired cash, and
this quantity exceeds the legal minimum.
To conclude otherwise would imply that banks are insensitive to carrying excess cash balances, or put another
way, that banks are not profit maximizers.
Explaining the interaction of legal and operational
factors is more difficult in the case of the member
bank than the nonmember bank. For the member
bank, only vault cash and balances held with Reserve
banks are eligible reserve assets.
The amount of
such balances held must at least equal the legal
Member bank reminimum reserve requirement.
serve assets may also yield an implicit return in the
form of correspondent services, however,
By virtue
of membership in the Federal Reserve, the member
bank gains access to System services. The required
3 A number of states, including
Maryland
and Virginia in
the Fifth District,
also count earning assets toward fulfillment of the required reserve [2]. In this analysis, that
portion of the legal reserve requirement
that can be met
using earning
assets is not considered
a cash management constraint,
and is therefore
ignored.

FEDERAL RESERVE BANK OF RICHMOND

19

reserve is in this sense comparable to a compensating
balance held with a correspondent
bank.
Unlike
compensating balances held with private correspondent banks, however, the compensating balance held
with rhe Reserve bank does not vary depending on
the quantity of services consumed. Rather, the compensation paid for access to System services is fixed
by the legal reserve requirement.
Some important correspondent services (e.g., Ioan
participations
and investment guidance)
are not
available through the Federal Reserve, Moreover, it
is known that many small member banks make little
use of System services [ 1, 71. For these reasons,
most member banks also obtain services from private
correspondents and hold due from balances in payment.
Member bank due from balances might be
termed supplementary correspondent
balances, since
they are held primarily as payment for services not
received through the Federal Reserve. These supplementary balances could equal zero, or be close to
zero, if System services fulfilled the greatest portion
of the member bank’s needs.
Computation of the legal reserve does not of itself
fully explain the total cash asset requirement resulting from the comparison bank’s status as a member
of the Federal Reserve System.
A more complete
explanation of the effect of System reserve requirements must take into account not only the required
reserve ratio, but also the type of assets eligible to
meet the requirement and the degree to which member bank correspondent service needs are met by the
Federal Reserve.
These various effects are captured in a measure that includes the legal minimum
combination of reserve assets and supplementary due
from balances. Including member bank holdings of
correspondent balances in the calculation of the cash
asset requirement accounts for (1) the fact that due
from balances are not eligible reserve assets and (2)
the possibility that System services do not completely
satisfy bank correspondent
service demands.
The
System reserve requirement is binding if a lowering
of the legal reserve ratio causes the member bank to
reduce its holdings of Reserve bank balances. This
occurs only if the amount of cash assets desired for
liquidity purposes is less than the total of legally
required cash assets plus supplementary
due from
balances. The System requirement is nonbinding if a
lowering of the legal reserve ratio does not cause the
member bank to reduce its holdings of Reserve bank
balances. In this case, the liquidity requirement at
least equals the total of legally required cash assets
plus supplementary due from balances.
20

ECONOMIC

REVIEW,

Previous ‘empirical studies provide information
about how the operational factors and legal factors
described above actually affect nonmember and member banks. First of all, the evidence suggests that
state reserve requirements are nonbinding [3, 6].4
Moreover, it has been shown that, on average, member banks hold greater proportions of cash assets
than do nonmember banks [ 5, 91. Taken together,
these results lead to the conclusion that the proportion of cash assets held by member banks taken as a
group is more than necessary to satisfy normal operating requirements.
This further suggests that Federal Reserve System reserve requirements,
unlike
those of the various states, are binding.
The remainder of the article will examine how
these operational and legal factors affect Fifth District member and nonmember banks of various sizes
and within different states. Tests will be conducted
to determine if state and Federal reserve requirements are binding or nonbinding.
Also, differences
in actual cash asset to total deposit ratios of member
and nonmember banks will be computed.
Fifth District
Reserve
Requirements
and Required Nonearning
Cash Assets
The Iegal and
administrative
reserve requirements and reserve accounting procedures for the five Fifth District states
and the Federal Reserve System are catalogued in
Table I. This summary, which covers deposits subject to reserve requirements,
reserve requirement
ratios, and eligible reserve assets, indicates there is a
great deal of variety within the District regarding
statutory
bank reserve provisions.
Two states’,
Maryland and North Carolina, provide for an adjustment to deposits subject to reserve requirements, as
does the Federal Reserve. One state, North Carolina.,
has graduated reserve ratios tied to the amount of
demand deposits held and to the maturity of timle
deposits, as does the Federal Reserve. Also, interestbearing securities are eligible as part of the required
reserve in Maryland and Virginia.
Bankers and bank regulators commonly focus on
statutory reserve requirements,
and especially on
required reserve ratios, as guidelines to measuring
differences in member and nonmember bank cash
positions.
Such comparisons
sometimes consider
effective reserve requirement
ratios, i.e., statutory
reserve ratios adjusted to exclude that portion of the

4 While Goldberg
and Rose [3] conclude
that the effect
of state reserve
requirements
on nonmember
bank cash
positions
is positive and statistically
significant,
they also
show that it is insubstantial.
SEPTEMBER/OCTOBER

1978

Table I
SUMMARY

OF LEGAL RESERVE REQUIREMENTS AND RESERVE ACCOUNTING
Fifth District State,

and

August
Deposits Subject to
Rescns Req”iremen+s

Authority

Resent

Demand

Time

Total demand
depo,i+s loss
colloterolirad

Maryland

Totaltime

1978

Requirement Ratio

Demand

lime

15%

Demand

Corolino

time

Time

at least
6636%

Vault cash
Due from bank,
U. S. Govt.
sewritier
Store of Md.
racurities
Approved obligotions of Md.
municipalities

North

1

of totoi
resene

U. S. Govt.
recvritiss
State of Md.
securi+ies

“p
I

to

33!6%
of +o+ol
reser”s

!

3%

Vovl+ cash
Due from honk,
CIPC with o
rtonding of
10 day, or less

Vault ash
Dva from honk,
CIPC with o
rtonding of
10 days or less

3%

Vault cash
Due from book,
CIPC

$ millions

Savings ond time

deposit, less
colloterolizcd
deposit, of
public fund,.

o-2
-8%
2.10 -10%
10.100....12%
100.400....13%
**or 400..-15%

open occOUn+ 3%
Other time
maturing in
180 day,
or more
3%
maturing in
less than
180 doy,
O-5 million . ...3%
*“or 5
million _,_._....___
6%

South Corolino

Totol demand
deposits.

Total time
deposit,.

7%

Virginia

Total demand
dcpo,i$, net of
r&prowl
baloncc*.

To+ol time
deposit, net of

10%

reciprocal
ba,ansor.

7%

3%
Vovlt

cash

\

at least
20% of
to+01
reserve

IThere

are

legol

Tot01 dcmond
deposit, loss
ClPC and
demand bolonces
due from
commercial
banks.

minimvm

and

Totol time
deposit,.

maximum

limit,

$ million,
0.2
-7%
2.10 . ...P’h%
lo-100....11’4%
100.400....12%%
*“or 400....16’/r%

Savings2
.._.___.
3%
Time 0.5 million”
maturing in
30.179 days -3%
180 doys4 yrr
214%
4 yrs 01 mom ..l%
Time over
5 million2
maturing in
30-179 days . ...6%
180 days4 yrr
. . . . 2Ya%
4 yrr or more ..l%

Con+empamnwus
rest,“* accoun+ina
on a doily basis.
No formal penoltie
for reserve
deficiencies.
Reserves computed
from opening
de,,&+
figure,

“P +a

\

25% of
+O+Ol
restI”*

at lea,+
Vovlt

cash

1
Due from honk,

Due from banks
CIPC

Fcdeml Reserve
SYSlted

r*sc~s clcco”n+ing
using a doily
a”er.aga based on
a 14 doy period.
No formal penoltie
for re**n*
deficioncie,.

Vault cash
Due from bank,
ClPC

Short term
U. S. Go”+.
resvritier

Total time
deposit,.

Con+smporoneo”,

Vault cash
Due from bank,
CIPC

Totol

Totol demo-d
deposits.

C~“+tltlpO~O”tO”,
resent accounting
on q doily bcsi,.
No formal penaltie:
for ,e,erv*
deficiencies.

Vault cash
Due from bank,

Vavlt cash
Due from bank,
CIPC

Total dsmond
deposit, less
collo$croli,ed
deposit, of
public fund,.

West Virginia

Reserve Accountin+
Procedure,

Eligible Reserve Asset,

3%

deposit, less
collo+erolired
deposit, of
public fund,.

deposit, of
public fund,.

PROCEDURES

Federal Reserve System

CIPC

Vault co,h
Deposit, with
P.R. Bank,

Vault cash
Deposit, with
F.R. Banks

20% of
totO
reserve

(one-day log)
using a daily
overage based on
a 14 day period.
No formal penol+y
for reserve
deficiencies.
Reserve, computed
from ooenina
deposir figures
(ant-day
lag)
wins a daily
orsrige
b&d
on
a 14 day period.
Pen&y
for
reserve deficiencies
osrer,ed at 0 rate
of 2% per annvm
above +he lowest
rote opplimble to
borrowings
by
member book,
from the Federal
Re5el-W.

_

Two-week log usin
o doily overoga
based on a 7 dav
period.
Penalty .
for rssens
deficiencies
ossesssd at a ro+e
of 2% per o”n”nl
above the lower?
rote opplicobls to
borrowing,
by
member banks
from the Federal

on reserve requirement,.
Minimum

Maximum

Net dcmond:
Reserve city bank,

10

Source:

of reserve, on saving,

Fedaml

Raewe

and other time dcpo,itr

gullstks, relevant

14

3

Time
2 The oreroge

22

7

Other bank,

10

must be a$ least 3 percent, the minimum

r+o+u+es of the various

state,,

specified by low.

ond state banking depohsnt,.

FEDERAL RESERVE BANK OF RICHMOND

21

required reserve that can be held in the form of
earning assets. Their widespread use notwithstanding, comparisons of this general type are faulty on at
least two counts.

requirements applying to Fifth District banks are
nonbinding, the statutory guidelines listed in Table I
are used to compute the required nonearning asset
reserve expressed as a percentage of total deposits
for four size groupings of member and nonmember
banks. The four groups: based on total asset size,
are under $10 million, $10-25 miliion, $25-50 million,
and $SO-100 million, respectively. These size groupings contain 333 member and 346 nonmember in-,
sured commercial banks as of June 30, 1977. The
procedure followed is essentially that used by an
individual commercial bank in computing its required
reserve, except that in this instance banks of like
size have been grouped together.
,411 required nonearning asset ratios are computed using June 30,
1977 Call Report data.”
In Maryland and Virginia, where securities are
eligible reserve assets, the legal reserve ratio is adjusted downward using the formula

First, effective reserve requirements often give an
unclear picture of aciual reserves required.
For
example, as commonly used, effective reserve requirements ignore adjustment of the total deposit
base for such things as UPC, due from balances,
and government deposits. As Table I shows, these
adjustments
are important for Maryland,
Korth
Caroiina, and the Federal Reserve.
Moreover, it is
difficult to make any generalization about the impact
of effective reserve requirements on banks of varying
sizes within states, since the mix of demand and time
deposits often varies by bank size. Deposit mix may
also vary considerably among states, thus complicating attempts to classify states according to reserve
stringency.
In Table I, South Carolina and West
Virginia are shown to have the same effective reserve
requirement.
Inasmuch as South Carolina banks
hold much larger proportions
of demand deposits
than do West Virginia banks, however, it might be
expected that actual required reserves would be considerably larger in South Carolina [S].
This is
shown to be the case in Table II.

ER =
where :

effective

reserve

ratio ;

P =

proportion of reserve that can be
held in earning assets; and,

R =

statutory

reserve

requirement.

This adjustment is made to exclude the influence of
provisions that allow earning assets to be held as
part of the legal reserve.

The second, more serious, drawback to relying on
effective reserve requirements as guidelines to actual
bank cash positions is the possibility that reserve
requirements are nonbinding.
As mentioned in the
first section of this article, there is evidence to suggest that this is the case for many nonmember banks.
As a step toward testing the hypothesis that reserve

B Tests reviewed
in another
study [7] suggest
that miciyear Call Reoort data on Fifth District
bank cash asset
positions
can-be validly used as proxies for bank behavior
averaged
over longer time periods.

Table

REQUIRED NONEARNING

ER =

(l-P)R,

Ii

CASH ASSETS AS A PERCENT OF TOTAL DEPOSITS

Member

and

Nonmember

Banks by Size Group

Fifth District States
Calculated

from

6-30-77

Call

Report

Asset Sire Groups,
Under

Millions

of

Dollars

50-100

25-50

1o-25

To

_

Member

Nonmember

Member

Nonmember

Member

Nonmember

Member

Maryland

.0413

.0262

.0426

.0295

.0454

.0337

-0560

.0376

North

Carolina

.0401

.0428

.0446

.0395

.0465

.0487

.0572

.0484

Sowth Carolina

.0495

.0475

.+x11

.0472

.0552

.0495

.0535x

.0468

Virginia

.0387

.0470

a417

.0454

.0428

.0439

.0486

.0496

West

.0395

.0429

.0432

.0423

.0439

.0419

.0477

.0419

State

Virginia

1 Fewer

22

than

three

banks

in group.

ECONOMIC

RHEW,

SEPrEMSER/OCTOBER

1978

Nonmember
--

In Maryland and North Carolina, the deposit base
subject to reserve requirements is net of collateralized deposits of public funds. It is assumed that all
government
deposits are collateralized,
and such
deposits are therefore deducted from total deposits
to arrive at a net deposit base.

The June 30, 1977 required nonearning asset reserves expressed as percentages of total deposits are
presented in Table II. Comparisons show that member banks’ required nonearning asset reserve ratios
are lower than nonmember banks’ ratios in seven
out of a possible twenty groups. These groups are:
North Carolina, under $10 million and $25-50 million ; Virginia, under $10 million, $10-25 million,
$25-50 million, and $50-100 million; and West Virginia, under $10 million. An unweighted average of
the differences in member-nonmember
bank ratios by
size group and across states shows that member bank
required nonearning asset reserve ratios are higher
by .05 percent, .39 percent, .32 percent, and .77 percent, in ascending order of asset size. Perhaps the
most striking feature of Table II is the narrow
average differential that exists between member and
nonmember bank required nonearning cash asset
ratios, especially for the smaller size groups.
It is
also important to consider, however, the relationship
that exists between these required ratios and actual
bank cash asset ratios.

Federal Reserve and North Carolina required reserve ratios on time deposits are graduated
by
amount held and maturity classification.
Inasmuch
as the Call Report does not provide deposit breakdown by maturity class, assumptions must be made
as to time deposit maturity structure.
The July 27,
1977 Fifth District Survey of Time and Savings
Deposits is used to derive ratios showing the proportion of total time deposits held in amounts less
than $100 thousand in specific maturity classifications
to total time deposits in amounts less than $100
thousand. These ratios are used to calculate member
bank and North Carolina nonmember bank required
reserves against time deposits of less than $100
thousand.
The June 30, 1977 Fifth District survey
of maturity distribution on weekly reporting bank
negotiable CD’s is used to derive ratios showing proportions of time deposits held in amounts greater
than $100 thousand in specific maturity classifications
to total time deposits in amounts greater than $100
thousand. These ratios are used to calculate member
bank and North Carolina nonmember bank reserves
against time deposits in amounts greater than $100
thousand.

A Review of Actual Cash Asset Positions
Actual cash asset to total deposit ratios are shown in
Table III for the same forty groups of banks appearing in Table II. The types of nonearning cash
assets that make up Table III include demand balances due from U. S. banks, currency and coin, and
deposits with the Federal Reserve.
These are the

Table

111

ACTUAL CASH ASSETS AS A PERCENT OF TOTAL DEPOSITS1
Member

and Nonmember

Banks by Size Group

Fifth District States
Calculated

from 6-30-77

Call Report

Asset Size Groups,
Under

10

Millions of Dollars

10-25

25-50

50-100

Member

Nonmember

Member

Nonmember

Member

Nonmember

Member

Maryland

.0946

.0639

.oa70

.0669

.0828

.0824

.0964

.oa95

North

Carolina

.0886

.1053

.Q867

.OB81

.0780

.0798

.1141

.0615

South

Carolina

.1281

.1095

.1021

.08B5

.1086

.OB17

.10742

.OB76

Virginia

.0821

.0843

.0812

Ma3

-0747

.0597

.0772

-0842

West

.1082

.0862

.oa52

.0669

.OB67

A667

.0872

.D443

State

Virginia

Nonmember

1 Includes demand balances due from U. S. banks, currency and coin, and deposits with the Federal Reserve; excluded are CIpC, other
Together, these six items make
balances due from U. 5. banks (e.g., interest bearing balances) and balances due from foreign banks.
up asset item 1 on the Report of Condition, “cash and due from banks.”
2Fewer

than

three

banks

in group.

FEDERAL RESERVE BANK OF RICHMOND

23

same categories of cash assets whose properties
considered in the first section of this article.g

are

Comparing nonmember bank required nonearning
cash asset ratios in Table II with actual cash asset
ratios in Table III supports the conclusion that state
reserve requirements
in the Fifth Federal Reserve
District are nonbinding.
In every case but one
(West Virginia $50-100 million), nonmember actual
cash asset ratios exceed required cash asset ratios
by a substantial margin.
Evidently, the proportion
of cash required by Fifth District nonmember banks
for operating purposes exceeds the proportion required for meeting the legal reserve. Strictly speaking, a similar comparison for member banks is not
relevant, inasmuch as the legally required nonearning
cash ratios do not account for supplementary
due
from correspondent
balances.
The question of whether or not Fifth District state
and Federal Reserve System reserve requirements
are binding can also be addressed using regression
analysis. Using this method of analysis leads to the
conclusion that the state reserve requirements are
nonbinding while System reserve requirements are
binding. Interested readers are referred to the Appendix for the detailed results.
It is relevant

to compare member and nonmember
bank actual nonearning cash asset ratios.
Having
shown that the nonmember ratios represent cash balances desired for operating purposes, comparison of
these ratios with member bank ratios will indicate
if the member bank size groups hold greater proportions of cash assets than are necessary according to
the nonmembers’ operating criteria. This appears to
be generally the case. Member banks’ actual nonearning cash asset ratios in Table III are lower than
nonmember banks’ ratios in only five of the groups
(down from seven in Table II) .? These groups are :
North Carolina, under $10 million, $10-25 million,
and $25-50 million; and Virginia, under $10 million
s Including
CIPC
in the calculations
would
tend to
eliminate
any bias toward
overstatement
in nonmember
compared
to member bank ratios arising from differences
in accounting
procedures
described
in footnote 2. On the
other
hand, including
CIPC
would also tend to bias
unward
member
comnared
to nonmember
bank ratios
to the extent
that member
banks act as correspondent
clearing
banks.
These offsetting
biases are difficult
to
measure,
and therefore
comparisons
of actual cash asset
ratios that include CIPC are hard to interpret.
The basic
conclusions
reached
using the ratios in Table III, however, are not substantially
different
from those based on
ratios including
CIPC.
7 If CIPC are included in the calculations,
member banks’
actual nonearning
cash asset ratios are lower than nonmember
banks’ ratios in only two of the groups.
These
are: North Carolina, under $10 million and $25~50 million.

24

ECONOMIC

REVIEW,

and $50-100 million. Moreover, in only one of these
five cases is the member bank group’s ratio substantially lower (more than 1 percentage point lower)
than the comparison nonmember bank ratio.
An unweighted average of the differences in member-nonmember bank ratios by size group and across
states shows that member bank cash asset ratios are
higher by 1.05 percent, 1.27 percent, 1.25 percent,
and 2.30 percent, in ascending order of asset size.”
These average differences are considerably greater
than those prevailing between member and nonmember required nonearning asset reserve ratios.
They suggest that, on average, Fifth District nonmember banks less than $100 million in asset size
have available for investment from a little over 1
percent to 2.3 percent more of total deposits than do
their member bank counterparts.
Conclusion
This article has shown that state
reserve requirements in the Fifth Federal Reserve
District applying to smaIIer sized banks are nonbinding, i.e., nonmember banks’ operating cash requirements exceed legally required cash by a substantial margin.
An implication of this is that a
lowering of state reserve requirement ratios would
not cause nonmember banks to reduce their holdings
of cash assets. Conversely, Federal Reserve System
reserve requirements applying to smaller banks are
shown to be binding, i.e., member banks would likely
hold fewer cash assets if System requirements were
lowered.
On average, Fifth District member banks less
than $100 million in asset size maintain higher actual
cash asset ratios than similarly sized nonmember
This evidence suggests that, on average,
banks.
member banks hold more cash assets than required
purely for operating purposes.
The primary reason
for this is that only vault cash and deposits with the
Federal Reserve, but not correspondent balances, are
eligible reserve assets for member banks.
These
banks hold correspondent balances to pay for correspondent services in addition to holding reservable
assets.
It is important to note that this analysis treats all
member and nonmember banks alike for purposes of
comparison, i.e., the analysis has been limited to d%cussion of the average cash asset ratios of member
s If CIPC are included in the calculations.
the unweighted
averages
show member bank cash asset ratios are hygher
by 1.39 percent,
1.88 percent,
1.37 percent,
and 3.11 percent, in ascending
order of asset size.

SEPTEMBER/OCTOBER

1978

and nonmember banks. Yet, the article
out that member banks are not all alike
how heavily they use Federal Reserve
vices. It might be that heavy users of

also points
in terms of
System serSystem ser-

vices are able to minimize their due from balances
and thereby reduce their overall cash asset ratios. A
forthcoming article will examine the effect of use of
System services on member bank cash asset positions.

References
1. Gilbert, R. Alton.
“Utilization
of Federal Reserve
Bank Services by Member Banks: Implications for
the Costs and Benefits of Membership.”
Review,
Federal Reserve Bank of St. Louis, (August 1977))
pp. 2-15.
2.

Quick, Perry D. Appendix A to “The Burden of
Federal Reserve Membership, NOW Accounts, and
the Payment of Interest on Reserves,” by the staff
of the Board of Governors of the Federal Reserve
System. Mimeographed, Board of Governors of the
Federal Reserve System, June 1977.

, and Lovati, Jane M. “Bank Reserve
Requirements and Their Enforcement:
A Comparison Across States.” Review, Federal Reserve Bank
of St. Louis, (March 1978)) pp. 22-32.

Summers, Bruce J.
“Required
Reserves, Correspondent Balances and Cash Asset Positions of
Member and Nonmember Banks: Evidence From
the Fifth Federal Reserve District.”
Federal Reserve Bank of Richmond,
Working
Paper 78-3,
April 1978.

“Do
3. Goldberg, Lawrence G., and Rose, John T.
State Reserve Requirements Matter?”
Journal of
Bank Research, (Spring 1977), pp. 31-39.
4. Knight, Robert E.
“Account
Analysis in Correspondent Banking.” Monthly Review, Federal Reserve Bank of Kansas City, (March 1976)) pp. 11-20.
5.

“Perspectives on Fifth District Banking: 1960-1976.” Economic Review, Federal Reserve
Bank of Richmond, (March/April
1978), pp. 2-16.

8.

. “Comparative
Burdens of Federal Reserve Member and Nonmember Banks.”
Monthly
Review,
Federal Reserve Bank of Kansas City,
(March 1977)) pp. 13-28.

9. Varvel, Walter A. “The Cost of Membership in the
Federal Reserve System.” Federal Reserve Bank of
Richmond, Working Paper 77-1, March 1977.

APPENDIX
The relationship
actual

shows no
yields

between

cash asset to total
significant

a R.’ of

The regression

.23

the data

deposit

correlation
and

a

in Tables

ratios in Table
between

significant

the

variables

t-statistic

results are:
Adjusted

(1)

cash

assets

Total deposits

Adjusted

(2)

.Ol and

[

with
The figures

in parenthesis

These results support
requirements
the

variation

are

partially

in Fifth

are

i2

=

.23 and

for
the

nonmember
right

1.
1
=

.052

+

=

=

For member
(the required

Required

X

(1.102)

.032

=

banks.
variable

analysis.

cash asset to total

nonearning

+

1.316

banks,

assets

[

Required

(2.629)

nonearning

of the

ratios in Table II

however,

reserve

Total deposits

X

Regression

deposit

1.61; and,

m

D-W.

hand

0.608

using regression

nonearning

to total

this regression
deposit

ratio).

nr
1

assets

Total deposits
[

I

m,

1.80.

t-statistics.

the idea that state
binding.

District

for

D.W.

cash assets

Total deposits

111 can be analyzed

II

[
with F2 =

II and

III on the required

reserve

The regression

member

bank

requirements

in the Fifth District are nonbinding,

results suggest that reserve requirements

holdings

of

explain

while
roughly

System reserve
one-quarter

of

cash assets.

FEDERAL RESERVE BANK OF RICHMOND

25


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102