http://www.newyorkfed.org/aboutthefe...int/fed45.htmlReserve Requirements
Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or on deposit at a Federal Reserve Bank.
Reserve requirements represent a cost to the banking system. Bank reserves, meanwhile, are used in the day-to-day implementation of monetary policy by the Federal Reserve.
As of December 2006, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time deposits.
Reserve requirements are the portion of deposits that banks may not lend and have to keep either on hand or on deposit at a Federal Reserve Bank
The Monetary Control Act (MCA) of 1980 authorizes the Fed's Board of Governors to impose a reserve requirement of 8% to 14% on transaction deposits (checking and other accounts from which transfers can be made to third parties) and of up to 9% on nonpersonal time deposits (those not held by an individual or sole proprietorship). The Fed may also impose a reserve requirement of any size on the amount depository institutions in the United States owe, on a net basis, to their foreign affiliates or to other foreign banks. Under the MCA, the Fed may not impose reserve requirements against personal time deposits except in extraordinary circumstances, after consultation with Congress, and by the affirmative vote of at least five of the seven members of the Board of Governors.
In order to lighten the reserve requirements on small banks, the MCA provided that the requirement in 1980 would be only 3% for the first $25 million of a bank's transaction accounts, and that the $25-million figure would be adjusted annually by a factor equal to 80% of the percentage change in total transaction accounts in the United States. An adjustment late in 2006 put the amount at $45.8 million. Similarly, the Garn-St. Germain Act of 1982 provided for a 0% reserve requirement for the first $2 million of a bankÂ’s deposits. This level, too, rises each year as deposits grow, but it is not adjusted for declines in deposits. As of December 2006, that level is $8.5 million.
The transactions-account reserve requirement is applied to deposits over a two-week period: a bank's average reserves over the period ending every other Wednesday must equal the required percentage of its average deposits in the two-week period ending the Monday sixteen days earlier. Banks receive credit in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. Banks that fail to meet their reserve requirements can be subject to financial penalties.
Reserve Requirements and Money Creation
Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). (Isn't that creating another $900 out of thin air that is interest bearing debt???)In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.
Reserve Requirements and Monetary Policy
Reserve requirements, the discount rate (the interest rate that Federal Reserve Banks charge depository institutions for short-term loans), and open market operations (the buying and selling of government securities) are the Fed's three main tools of monetary policy. There is a continual flow of reserves among banks, representing the ever-changing supply and demand for these reserves at individual banks. When the Fed engages in open market operations, it adds to or subtracts from the supply of reserves. The effectiveness of the Fed's actions result from the reasonably predictable demand for reserves that is created by reserve requirements.
The Fed changes reserve requirements for monetary policy purposes only infrequently. Reserve requirements impose a cost on the banks equal to the foregone interest on the amount by which required reserves exceed the reserves that banks would voluntarily hold in order to conduct their business, and the Fed has been hesitant to make changes that would increase that cost. (Between 1980 and 1987 reserve requirements underwent a series of changes mandated by the MCA. Requirements on banks that were members of the Federal Reserve System were lowered, while those on nonmember depository institutions were raised gradually from zero to the final levels applied to the member banks.)
There have been only a handful of policy-related reserve requirement changes since the MCA was passed in 1980. In March 1983, the Fed eliminated the reserve requirement on nonpersonal time deposits with maturities of 30 months or more, and in September 1983, it reduced that minimum maturity to 18 months. Then, in December 1990, the Fed cut the requirement on nonpersonal time deposits and on net Eurocurrency liabilities from 3% to 0%. In April 1992, it cut the requirement on transaction deposits from 12% to 10%. In announcing its December 1990 move, the Fed noted that the cut would reduce banks' costs, "providing added incentive to lend to creditworthy borrowers." Similarly, in announcing its April 1992 cut in reserve requirements, the Fed observed that the reduction would put banks "in a better position to extend credit." Current reserve requirements are low by historical standards. From 1937 to 1958, for example, the rate on demand deposits was always at least 20% for banks in New York and Chicago, which were "central reserve cities"—a term now obsolete.
Before the passage of the MCA in 1980, only banks that were members of the Federal Reserve System had to meet the Fed's reserve requirements. State-chartered banks that were not Federal Reserve members had to meet their state's reserve requirements, which typically were lower. As a result, many banks dropped their Federal Reserve membership, and member bank transaction deposits fell from nearly 85% of total U.S. transaction deposits in the late 1950s to 65% two decades later, weakening the Fed's ability to influence the money supply. The MCA sought to solve this problem by authorizing the Fed to set reserve requirements for all depository institutions, regardless of Fed membership status.
The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.
May 2007
