Banks in the U.S. are currently required to hold reserves against their demand deposits at a marginal rate of 10%.  Several countries impose lower reserve requirements, and some have eliminated them altogether.  If the U.S. followed the trend and eliminated the requirement to hold reserves, how would that affect the lending of banks and the resulting money supply?  We will compare two cases:  a 10% reserve regime and a no reserve regime. 

In the U.S. 10% regime, no reserves are required on the first $10.7 million of demand deposits, 3% on the next $44.5 million, and 10% on any amount above.  A bank with demand deposits of $100 million must therefore hold a minimum of $5.815 million in reserves, which can be in any combination of vault cash and Fed funds.  Under normal conditions, the bank will hold enough vault cash to promptly respond to the net withdrawal of cash by depositors.  Let’s assume that it chooses to hold $3.315 million in vault cash for that purpose, and $2.5 million in Fed funds, thus holding no excess reserves. 

Under the latest rules, the Fed pays interest on Fed funds at 0.25 percentage points below the target Fed funds rate.  Assume the target rate has been set at 4%.  The bank will then receive interest payments on its Fed funds of $93,750 per year.

Now suppose the Fed eliminated the reserve requirement.  The need for vault cash would remain essentially unchanged.  However the bank would be holding $2.5 million in Fed funds which it no longer needs.  Other banks would likewise be holding excess reserves.  The immediate effect would be a large oversupply of reserves in the banking system, causing the Fed funds rate to drop to the interest rate it pays on those funds, thus losing effective control.  To regain control of the Fed funds rate, the Fed would sell securities from its own portfolio to restore the balance of supply and demand for reserves at its target interest rate.

If banks bought all of the securities offered by the Fed using their Fed funds in payment, the only change on their balance sheets would be on the asset side, swapping reserves for securities.  Their earnings would increase by the difference in interest they would earn on those securities versus the interest earned on Fed funds.  That difference would likely be very small, probably a fraction of a percentage point.

If non-banks bought all of the securities offered by the Fed, using their bank deposits in payment, the balance sheets of banks would shrink accordingly.  On the asset aside, banks would lose their reserves of Fed funds.  On the liability side their demand deposits would decrease by the same amount.  Their earnings would decrease by the amount of interest they previously received on their Fed funds.

Bank capital would remain unchanged regardless of who buys the securities.  Likewise there would be no change in bank capital when the 10% regime is replaced by the no reserve regime.  Thus the amount of new earning assets the bank could create through lending would remain unaffected.  The money supply would grow as it does in a 10% reserve regime, at a rate dependent on net demand for bank loans and the willingness of banks to lend.  Fed monetary policy and its implementation would remain basically unchanged.

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