Reserve Requirements and Monetary Policy

Reserve requirements are enshrined in introductory economics textbooks as one of the "tools," albeit a crude one, of monetary policy. Such regulations are understood to affect the banking system, and, ultimately, the economy by influencing the proportion of total assets that depositories hold as cash assets (either vault cash or balances with the Federal Reserve).

In recent years, different trends have emerged across industrial economies. The Bank of Canada has abolished reserve requirements. The new System of European Central Banks, in contrast, has established a 2-percent reserve requirement on almost all liabilities. In December 1990 and January 1991, the Federal Reserve reduced reserve requirements on non-personal time deposits to zero. Then, in April 1992, marginal reserve requirements on transactions deposits for the largest class of depositories were reduced from 12 percent to 10 percent.

In the absence of reserve requirements, depository institutions would continue to hold cash assets. Such assets are required to satisfy normal business operations, including settlement of interbank transactions (such as wire transfers and check clearing) and the exchange of retail deposits for currency on request. This represents a transactions demand for cash assets.

The evidence from recent U.S. data strongly suggests that the amount of cash assets demanded by most depositories now is determined by institutions' transaction demands. Under the legal reserve requirement ratios that were established in December 1990 and April 1992, and the "home-brewed" ratios allowed via the implementation of retail deposit "sweep" programs since 1994, reserve requirement regulations no longer are binding constraints on the portfolios of most depository institutions.

An environment in which the demand for cash assets by depositories is determined by transactions demands rather than regulatory constraints has several implications:

1. On March 26, 1998, the Board of Governors announced the return to a lagged reserve requirement structure, beginning July 30, 1998 (Federal Reserve Bulletin, May 1998, p. 337). Under the new system, the reserve computation ends two weeks before the beginning of the reserve maintenance period. Hence, depository institutions can know with certainty their level of required reserves before the maintenance period begins, and, similarly, the Federal Reserve can know the level of aggregate required reserves. In the near future, it is unlikely that this regulatory change will have any substantive effect on depository behavior, or on the conduct of the Fed's Open Market Operations.
2. It is important to distinguish between the concept of a reserve requirement as a pure tax (in exchange for which depositories receive no services) and as an implicit user charge for which the depositories receive clearing services from the Fed that are not explicitly priced. When legal reserve requirements are not binding constraints, the forgone interest from holding Federal Reserve deposits to meet a transactions demand should be viewed as a normal operating expense. Under these circumstances, payment of explicit interest on Federal Reserve balances would constitute a subsidy to the depository industry.
3. A number of recent studies conclude that funds rate volatility has not increased in recent years. This suggests that the evolution from an environment in which demand by depositories for cash assets is dominated by reserve requirements to one in which this demand is determined by patterns of payments activity does not introduce any fundamental problems for the current Federal Reserve operating procedures that are focused on federal funds rate objectives.

Changes in reserve requirements in the U.S. over the past decade are consistent with reducing the regulatory burden on depository institutions, but have not had a significant impact on the ability of the Federal Reserve to conduct monetary policy.

A longer version of this article will be published in the Jan./Feb. issue of the St. Louis Fed's Review.