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:
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.