|Y2K and Bank Reserves
The Y2K problem involving legacy software
that used the 2-digit format
to record the year in dates before 2000 is now a thing of the
But the threat to our financial system, which is highly dependent, on
was real enough.
Banks normally hold reserves amounting to a small
fraction of their
deposit liabilities. In early 1999 commercial banks in the
held about $40 billion in reserves to cover checking deposits that
over $600 billion. In anticipation of a demand from the public
a large increase in cash holdings in late 1999, the Fed increased its
stockpile of notes to about $200 billion to be made available to banks
as needed. Even if the public drew down their bank deposits for
by only one-fifth of that amount, it would have depleted the entire
of the banking system.
Obviously something had to be done or the interbank
lending rate, i.e.
the Fed funds rate, would have soared as banks scrambled for
Many banks would have simply been unable to cover the demand for cash
Here is essentially what the Fed did in order to avoid the
The Fed's Response
The Fed purchased securities from banks and other
as required to supply the needed banking system reserves. By
the demand as fast as it arose, it kept the supply and demand in
at its target Fed funds rate. Aggregate reserves were thus held
unchanged even as the monetary base increased by the amount of cash
withdrawn, about $40 billion.
After the smoke cleared in early 2000, people returned
cash into their bank accounts. That would have flooded banks with
excess reserves and caused the Fed funds rate to collapse.
the Fed sold securities from its own portfolio, to soak up the
Again it did so as fast as necessary to stabilize the Fed funds
The monetary base shrunk accordingly.
What Really Controls the
The details of what happened are somewhat more complex
here, but the effects on the monetary base were real. Whether
provide cash to depositors or make loans to borrowers, the decisions of
the public determines the need for banking system reserves, and
the amount that must be supplied by the Fed. If the Fed failed to
do so, it would lose control of the Fed funds rate, the benchmark for
short-term interest rates. More importantly, the loss of
would endanger the payment system itself in which the banks play a
role. That is not an acceptable option.