Required Reserve Ratio: All or Nothing?
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Origins of the Federal Reserve
The first institution resembling a central bank in the United States was the First Bank of the United States, chartered in 1791 by Alexander Hamilton. The project was later abandoned in 1811. In 1816, the Second Bank of the United States was chartered; but like its predecessor, its charter was not renewed in 1836. Between 1837 and 1862, a period of time known as the Free Banking Era existed where there was no formal central bank. From 1862 to 1913, a system of national banks was instituted by the 1863 National Banking Act. Due to a collection of bank panics in 1873, 1893, and 1907, strong demand for the creation of a centralized banking system emerged in order to provide stability to this increasingly shaky sector.
After the panic of 1907, congress created the National Monetary Commission to draft a plan for reform of the banking system. Senate Republican leader and financial expert Nelson Aldrich was the head of the Commission. Aldrich heavily surveyed the system European central banks had followed, discovering that Britain and Germany had far more advanced and efficient systems. Aldrich developed a comprehensive plan, but he was unable to pass it due to the prevalence of anti-bank sentiment among Democrat leaders.
President Woodrow Wilson had to outmaneuver the agrarian wing of the Democratic Party, which vehemently opposed Wall Street. Those from the farming communities wanted a government-owned central bank which could create money at Congress bequest. Wilson was able to convince them that due to the fact Federal Reserve notes were obligations of the government, the plan coincided with their wishes.
It was argued that because the system was decentralized into twelve separate districts, it would weaken New York as the monopoly holder of market activity and strengthen other areas of the country. Congress passed the Federal Reserve Act in 1913. The Fed began operations in 1915 and played a major role in financing the Allied and American war efforts during World War One.
Fractional Reserves first came into being as early as 1820, where the idea was to increase the liquidity of bank notes by ensuring their convertibility into gold. However, the vast majority of financial institutions did not have legal reserve requirements prior to the Civil War in 1861.
The National Bank Act of 1863 changed all of that with the advent of the first national required reserve for banks who united under a new network which allowed bank notes to be circulated more easily throughout the country.
A series of bank runs and financial panics, particularly during the Great Depression proved that reserve requirements could not guarantee the convertibility of deposits for the entire banking system. In essence, reserve requirements were really no help in providing liquidity during a panic beacause any given dollar of reserves could not match both the money demand of the customer as well as the required reserve.
History of Reserve Requirements
Historical Assessment of the Rationales and Functions of Reserve Requirements
Is the Federal Reserve System Really Necessary?
"Is the Federal Reserve System Really Necessary?": Reply
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How the System Works
The Federal Reserve System has three major components:
1.) 12 individually chartered corporations called Federal Reserve Banks and member commercial banks in each District that contribute capital to the Reserve Banks and receive dividends
a) The Federal Reserve System is made up of 12 Federal Reserve Districts, or service areas. Although the Reserve Banks were created by a legislative act, they receive no budget appropriations from Congress. Each Reserve Bank is self sufficient, earning income from interest on holdings of U.S. Treasury securities, from interest on loans to depository financial institutions, and from fees for the services provided to those institutions.
The stock of Reserve Banks is owned entirely by the commercial banks that are members of the Federal Reserve System. Dividends are paid semiannually to stockholders at a fixed rate of 6 percent.
At the end of each year, Reserve Banks return to the U.S. Treasury all earnings in excess of expenses necessary for operations.
2.) The Board of Governors of the Federal Reserve System, a federal government agency that exercises general supervision over the Reserve Banks.
a) The Board of Governors in Washington, D.C., provides general oversight of the Reserve Banks. The Board is composed of seven members who are appointed by the President and confirmed by the Senate to serve 14-year terms. These terms are staggered so that one expires every two years.
4.) The Federal Open Market Committee, the main body for carrying out monetary policy.
a) The Federal Open Market Committee (FOMC) is the System's main body for carrying out its most important role in the U.S. economy: the formulation and conduct of monetary policy.
5.) Where does the Required Reserve Ratio fall into this system?
The Fed has three main tools to do this job. The most important is to set the federal funds rate, which is what banks pay each other for overnight loans. The committee sets a target for this rate, but not the actual rate itself. When the news media report that the Fed changed interest rates, it's the federal funds rate that is being referred to.
The second tool is the discount rate, which is what banks pay to borrow money from a Federal Reserve Bank. This is usually lower than the federal funds rate, but the two are closely tied.
The third tool is the reserve requirement. The Federal Reserve dictates the percentage of receipts banks must hold in their vaults, thus possessing another tool in controlling the money supply. This is a percentage of deposits that all banks must hold in reserve and cannot loan out. This rate is usually around 10 percent, but it can change from time to time.
This is a map of the 12 Federal Reserve Districts in the United States
http://www.frbatlanta.org/publica/brochure/struct/images/FED_map.jpg]]
Below is a link to a table of Each country and its current required reserve ratio %
Table of International Reserve Requirements By Country
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What if the Required Reserve Ratio was 100%?
This system, in which all currency is backed up by another asset and banks are required to maintain 100% cash reserve ratio has never been implemented in any actual economy for good reason. However, the closest system is that of a "currency board", in which commercial banks are not required to maintain 100% cash reserve, but all the money in circulation is backed up by another asset held by the central bank.
http://www.gutterguard.net/images/100-percent-guarantee.jpg
If the reserve ratio of all banks was set at 100%, the deposit multiplier would be set equal to zero. In this system, commercial banks would have no incentive to offer savings or checking accounts unless bank customers paid a fee for the services.
In a fully-backed system, all bank deposits are transaction deposits which must be matched by reserves of base money at the Fed. Banks cannot create deposits through lending, as they do in a fractional reserve system. However they can accept deposits because the reserves backing them are necessarily transferred at the same time.
The total money supply consists of transaction deposits at banks and cash in circulation. Transaction deposits are the equivalent of cash and therefore earn no interest. For income, depositors can purchase Treasury bills, or a variety of short-term investments offered by private financial institutions (PFIs). That includes money market mutual funds which represent an interest in short-term debt while providing checking facilities against that debt. Except for Treasury bills, none of these securities are free of credit risk.
Credit cards are not allowed because they create bank deposits without full backing. However debit cards are acceptable since they do not create new deposits. They simply transfer deposits from buyers to sellers. Charge cards are also acceptable because they are private debts of buyers to sellers, and do not create new deposits.
In the 100-percent reserve requirement system, commercial banks now lose their function to create money independently through the inter-bank flow of excess reserves. The central bank holds the stock of money to provide to commercial banks in response to the need for money to finance output. This process itself reflects completely on real economic activities. The matching process between money and the real economy makes money a financing medium for generating output. This implementation of money is generated by a stock.
Prices and rates of return in the 100-percent reserve requirement monetary system are productivity driven within a complementary framework of factor utilization. Since the rate of growth of quantities of currency money matches with the rate of growth of output and is functionally related with the total productivity in terms of factors of production, therefore, the trade sector becomes a component of this total relation. Now the price of exports relative to the price of imports, which is defined as the term-of-trade, is driven by the same kind of complementary consideration in the production menu. The exchange rate as the relative price of a national currency is simply the relative price of exported-to- imported goods and services. This is productivity driven in the 100-percent reserve requirement monetary system relating currency money to the real economy. Hence, the exchange rate itself is productivity driven. Policy regarding monitoring the exchange rate is not independent of the money-real economic relationship. The exchange rate in this sense remains in a state of float depending simply on the market-institution interlinked capability of reinforcing the knowledge induction of the 100-percent reserve requirement monetary system.
Advantages:
The current system used is that of a lagged reserve requirements. This minimizes the accuracy of short-run control of the money stock. Since deposits changes in a certain week produce no change in required reserves that same week, there is no necessary connection between reserve injections and deposit creation in any given week the required reserve ratio against deposit changes in zero, a reserve requirement as far removed as possible from the stable 100 percent system.
As analysis of lagged reserved requirements makes clear, the short-run and long-run properties of a reserve requirements system may differ, suggesting the possibility of deliberately exploiting different short- and long-run properties in order to achieve different objectives simultaneously. A system with short-run a properties of 100 percent required reserves with fractional long-run properties would maximize the accuracy of monetary control while retaining the present the present arrangements in the credit markets.
A fully backed system should be more robust than the fractional reserve system. It should also help direct financial resources to more productive activities. With a single depository, all payments are transfers between accounts within a single bank, which allows for instant clearing, eliminates the nuisance of checking system float, and significantly reduces associated costs.
Disadvantages:
The transition to this system would not be easy. It would have to be carefully planned and phased in to give all parties adequate time to make the necessary adjustments. Banks and thrifts would have to close out their existing loans, since they represent credit money that is no longer allowed under a fully-backed system. Many bank loans would probably be purchased by other PFIs as investments. Without the depository role, banks would no longer need the same number of branch offices, and would likely sell there excess facilities to the Fed. A logical way to proceed would be to gradually increase the reserve ratio requirement on existing depositories until it reached 100 percent.
If a bank lost deposits rapidly enough the supplemental reserve requirement would be large and negative, possibly exceeding the basic reserve requirement. The bets way to handle this would be to permit the member bank to overdraw its reserves account at its Federal Reserve Bank up to the amount of the negative required reserves. This would compensate the bank for the weeks in which it has rapid increases in deposits, which would all be absorbed in required reserves.
A Proposal for Reforming Bank Reserve Requirements in the United States
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What if the Required Reserve Ratio was 0%?
Reserve requirements are on the wane worldwide. Central banks have been reducing or eliminating them in an effort to make financial institutions more competitive. The reason is: many countries no longer adhere to the traditional view of reserve requirements as a means to directly control the money supply.
Proponents of reserve requirements argue that low reserve balances may complicate monetary policy operations and increase short-term interest rate volatility. Critics of reserve requirements insist that lower reserve requirements remove a distortionary tax on depository institutions and need not complicate monetary policy operations.
Advantages
Monetary policy can be conducted in a world of low to zero reserve requirements. Nowadays, Central banks of many countries decrease reserve requirements to reduce bank costs and stimulate lending.
1) Central banks do not pay interest on reserve balances. The interest that is foregone on involuntarily held reserves is practically a tax that is either borne directly by the banks and their shareholders or passed on to customers via lower deposit rates, higher borrowing rates, or reduced services. As long as reserve requirements force banks to hold higher balances than necessary for normal business purposes, reserve requirements constitute a burden on depository institutions. The higher the level of reserve requirements, the greater the costs imposed on the private sector. Thus, elimination of required reserves invariably makes financial institutions more competitive.
2) The effectiveness of reserve requirements has been eroded by financial innovations that reduce the amount of reserve balances that banks are required to hold (most banks can meet their reserve requirements by holding vault cash rather that maintaining reserve balances at the Fed). Precisely because reserve requirements are a “tax”, banks have a strong incentive to bypass the depository system, which may redirect credit flows in ways that impair the efficiency of resource allocation.
Real-life examples
Several countries have significantly reduced or eliminated reserve requirements in recent years, taking different steps, based on their own unique institutional structures, to facilitate bank reserve management and the conduct of open market operations in a world of non-binding reserve requirements.
Canada, UK, Australia, New Zealand, Switzerland conduct their monetary policy without using reserve requirements. In these countries, reserve requirements were seen as a discriminatory and unnecessary tax that distorts financial intermediation; they were perceived as imposing a significant cost on banks, while, at the same time, having little operational use in monetary policy.
The Bank of England has adopted a more flexible operating procedure, often intervening in the money market several times a day to fine-tune the cost and availability of reserves to meet the clearing needs.
The Swiss National Bank has adopted a different approach: it is less accommodative in offsetting temporary fluctuations in clearing needs in comparison to the UK. Because of that, Swiss banks have to hold more excess reserves, but they also have access to the central bank credit at their own discretion.
In Canada, however, the elimination of reserve requirements was facilitated by the fact that the country, unlike the US, has a relatively small number of settlement institutions (there are only 12 direct clearers that are required to settle their transactions on the books of the Bank of Canada). At the time reserve requirements were eliminated, the Bank of Canada also made changes to its operating procedures to improve the efficiency and transparency of its policy actions.
Counter-examples
The EU and Japan’s banking system operate similarly to the US’ in that they maintain reserve requirements at a certain, however low, level. While these countries’ central banks still seek to target the money stock over longer periods of time, in the short run most use an interest rate operating procedure. Under such a procedure, reserve requirements play a different monetary policy role than that traditionally espoused. Reserve requirements are seen not as an instrument for directly controlling the money stock but rather as a tool for facilitating control over short-term interest rates.
Disadvantages
- Interest rate volatility (evidence and causality)
This is one of the concerns about zero reserve requirements. Some data suggested that volatility may be greater in countries with low or nonbinding rr. However, many researchers found that there is no clear relationship between reserve requirements and volatility: interest rate volatility may depend more on the mechanisms for providing liquidity to the settlement system than on the level of reserve requirements.
The amount of volatility depends on two factors: the size of the surplus/shortage for the system and the institutional mechanisms for providing or removing liquidity from the system.
- MS and MD shocks in presence of lower reserve requirements (for more information refer to [http://proquest.umi.com/pqdweb?index=2&did=395094&SrchMode=1&sid=3&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1164825516&clientId=4534 The Changing Role of Reserve Requirements in Monetary Policy])
Implication for US
The examples of Canada, UK, and Switzerland may be a sufficient proof that reserve requirements are not essential for the conduct of US monetary policy provided the Fed is sufficiently flexible in modifying existing mechanisms for providing liquidity to the banking system. In order to limit increases in interest rate volatility, the Fed should alter the frequency of reserve provision through open market operations - conduct them more often than once a day; this will provide more flexibility in adjusting to the size of the daily settlement balance need. Alternatively, the Fed could change the structure of the discount window, whose stabilizing function has diminished in recent years as banks have become increasingly reluctant to borrow from the Fed (which may be viewed by the bank's customers as a financial weakness).
[http://proquest.umi.com/pqdweb?index=0&did=473888&SrchMode=1&sid=2&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1164825284&clientId=4534 Reserve Requirements: History, Current Practice, and Potential Reform]
Monetary Policy without Reserve Requirements: Case Studies and Options for the United States
[http://proquest.umi.com/pqdweb?index=0&did=901645&SrchMode=1&sid=5&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1164825777&clientId=4534 Replacing Reserve Requirements]
[http://proquest.umi.com/pqdweb?index=0&did=412239&SrchMode=1&sid=6&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1164825920&clientId=4534 Is There Any Rationale for Reserve Requirements?]
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Friedman and a Fully-Backed Monetary System
Friedman and 100% Required Reserves
Milton Friedman, leader of the Chicago School, argues that the Fed did not cause the Great Depression, but accented its effects by contracting the money supply through massive open market sales “to clean up idle reserves” at the very moment that markets needed liquidity during 1931. Friedman has argued that the Fed could and should be replaced by a computer system that sets rates calculated from standard economic metrics.
In a fully-backed system, all bank deposits are transaction deposits which must be matched by reserves of base money at the Fed. Banks cannot create money through lending, as they do in the fractional reserve system. However they can accept deposits because the reserves backing them are transferred at the same time. Friedman has highlighted some of the benefits to this system in terms of prioviding liquidity in times of financial panic. In a fractional reserve, or partially backed system, bank runs can be disastrous as the bank can struggle to meet the demand deposits of its depositors while maintaining the legal amount of reserves required by law.
The total money supply consists of transaction deposits at banks and cash in circulation. Transaction deposits are the equivalent of cash and therefore earn no interest. For income, depositors can purchase Treasury bills, or a variety of short-term investments offered by private financial institutions (PFIs). That includes money market mutual funds which represent an interest in short-term debt while providing checking facilities against that debt. Except for Treasury bills, none of these securities are free of credit risk.
Credit cards are not allowed because they create bank deposits without full backing. However debit cards are acceptable since they do not create new deposits. They simply transfer deposits from buyers to sellers. Charge cards work because they are private debts of buyers to sellers, and do not create new deposits.
The Dual Role of Banks
In a fully-backed system, banks could continue to perform both roles. However they would have to hold reserves at the Fed to fully back their deposit liabilities. In addition they would need their own liquid assets, sufficient to manage cash flow in their investment activities. Thus a bank would need two separate accounts at the Fed, a reserve account and a liquidity account. When a bank spends, the Fed would debit the bank's liquidity account and simultaneously credit the reserve account of the seller’s bank. The seller would receive a new credit in his own bank account.
Friedman argued for such a system where all banks had to have 100% of their reserved fully backed by the Fed.
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Conclusion
Given the hypothetical choice between a 100% required reserve ratio and zero required reserves, we feel that having no required reserves is more beneficial to banks and the public as there are so many loans and credit out in the holdings of the public which cannot be precisely accounted for, resulting in a nearly impossible task to reign in these loans.
While a system without reserve requirements has merit, it does not come without some drawbacks. In such a system, there is an increased level of volatility in the interest rates, resulting in potential economic instability. Additionally, under zero reserve requirements, a central bank would have much more difficulty in controlling and manipulating the money supply.
However, in a fully backed system, banks would be far more restricted in their abilities to give out loans, rendering them virtually unable to generate profit. 100% reserve requirements would not only affect depository institutions but hurt their shareholders and customers. Such a situation could lead to a potential decline in investment and subsequent negative effects on the growth of the economy.
Reserve Requirements and Economic Stability
The Effects of Lower Reserve Requirements on Money Market Volatility
