Monday, March 22, 2010

"Eliminating Reserve Requirements"

There is one thing that is wondering around various commentators that I hope that you do not get caught up in. Ben Bernanke, Chairman of the Federal Reserve, is quoted, correctly it seems, in saying that he would like to see the eliminating of the reserve requirement.

Every commentator that I have seen so far is screaming and carrying on about how horrible this is that the Fed wants to eliminate bank reserves. They are a little confused. They apparently do not realize how banks function, especially within the United States and within the Fed.

Each bank in fact has two reserves. The bank keeps on hand possibly five layers of reserves. There is the cash on hand to meet the daily cash requirements of its customers. There is the digital balance it keeps on hand to meet the demand for check transfers and transactions. They also have reserves to cover loans that go bad, so that they can replace the demand deposit (checking account) balances. There is also part of their loan portfolio that consists of government bonds and other assets that may be turned into “cash” quickly. Finally, there is the capital account, made of the equity that was invested by the shareholders. (Note that the loan-loss account and the capital account may be kept in government bonds or other liquid assets.) Bernanke’s proposal has nothing to do with these account and reserves. He is not suggesting anything to do with a bank’s operating methods or what passes for safety in today’s banking environment.

The bank has one other “reserve”. It is the percentage of its demand deposits that it has to have deposited with the Fed. This deposit, called a reserve by the original legislation that set up the Fed, is not a reserve in any rational sense. The bank has to have these funds on deposit with the Fed by law and if by chance the percentage of the deposit vs. the amount of its demand deposits in the bank falls below the current requirement (today it is 10%, including cash in the bank’s vault, which is as low as I know of in the history of the Fed), then the bank must either move money immediately or borrow it from another bank (the inter-bank rate) or the Fed (the discount rate or Federal Funds rate).

It is this totally useless Fed deposit that Bernanke is suggesting be done away with. Which, on the face of it, doesn’t seem like a bad idea. I am interested in how Bernanke is going to carry forward the purpose of the Fed, which is to manipulate the money supply, expand bank lending, and make inflation a constant in our lives. It will be interesting to find out.

Actually, this isn’t anything worth paying much attention to, since it will not affect much that will make a difference. We will still have the Fed destroying our assets and ignoring that they are doing so.


  1. I disagree with describing those five levels of reserves. It mixes things from the Asset side and the Liabilities side of the bank's balance sheet.

    On the Liability side, the bank has its Capital and its Allowances for Bad debts. The others you mention (Cash on Hand, Digital balances, and government bonds) are methods of holding assets. Both these categories are called "reserves", but they're not the same.

    Also, the balances at the Fed *are* the digital reserves from the Asset side.

  2. Realist Theorist, yes, if you look on the balance sheet of a bank, the deposits at the Fed will be listed as a reserve (it is funded from demand deposits, so it is actually a liability). It isn't. My approach in my post was to identify funds that could be used as needed by the bank for the purpose of meeting obligations and withdrawals. The money on deposit at the Fed is frozen and not usable by the bank for any reason other than meeting the legal requirement imposed on the bank by the Federal Reserve Act. If Bernanke's suggestion is put in place, it is quite possible that the funds freed up for the bank may be put into loans, and will no longer be even a fictitious reserve.

    I realize that the accounting for the items I named does not place them all in the same category. I was not referring to the accounting but the practical issue of the availability of funds for meeting obligations and requirements of depositors, e.g., paying checks that are presented, meeting cash requirements, etc. In that sense both the funds that come from deposits, and thus are liabilities, and assets of the bank, capital and loan-loss reserves, are available for use. Loan-loss reserves are there specifically to replace demand deposits that are lost if a loan goes bad, and thus meet depositor requirements.

    The issue for a bank today is how to balance its need to make money by loaning out the deposits that it has vs. the potential needs of its depositors, and all of the funds in the bank are oriented around that issue. But the Fed deposit is out of the bank’s hands and unusable.


  3. The deposits that a bank keeps at the Federal Reserve are not shown as "reserves" on the liability side of the balance sheet. Traditionally, they are shown under "Cash"; however they may also appear under "Short Term Investments" as the fed now pays interest on them. Either way, the bank shows its Fed Deposits as an asset.