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The Role of
Bank Reserves
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A minimum level of reserves was once
regarded
as necessary to ensure that a bank could meet the withdrawal of
deposits.
However experience has shown that a well-run monetary system can
operate
successfully with no minimum reserve requirements. Examples
include
the UK, Canada, Australia, and Sweden. It is fair to ask then
what
purpose such requirements actually serve in the US system.
Adequate Reserves Do Not Imply
Solvency
Reserves comprise funds on deposit
at the Fed
plus vault cash. A bank can hold adequate reserves and
still
be insolvent if its total assets, including loans and securities, do
not
cover its liabilities. However a bank in good standing can always
borrow in the money market or at the Fed to meet its reserve
requirements.
The measure of a bank's solvency
is its capital,
i.e. assets minus liabilities. The Fed imposes a lower limit on a
bank's capital relative to its risk-weighted assets to provide a margin
against insolvency. That ratio is what ultimately limits a bank's
deposit creation through lending.
The Basic Function of
Reserves
Even with no minimum reserve
requirement, banks
would still have to hold enough reserves at the Fed to cover the checks
written by their depositors, and enough vault cash to meet the demand
for
currency. The Fed and other clearing banks typically require
payment
in reserve money which bears no credit risk, rather than direct
transfers
between private banks which do bear a credit risk.
Other Useful Functions
Reserve requirements in
conjunction with an averaging
period for reserve maintenance can provide a useful buffer against
disturbances
in the money market. For example, if there were an unexpected
fall
in a bank's reserves early in the maintenance period, the bank could
allow
its reserves to fall below the required amount temporarily. Later
it could hold an excess sufficient to restore the required average
level.
In the long run, reserve
requirements can also
influence the level of bank lending, deposit rates, and the quantity of
credit and deposits. The key questions to be decided are:
what
level of reserves to require, whether they are remunerated (receive
interest),
and whether they can be averaged over some specified period of
days.
The Trend Toward Zero Reserves
Unremunerated reserves are an
implicit tax on
banks, but it is their customers who ultimately pay. The interest
rate a bank charges on loans must reflect its operating costs.
In the U.S., the required reserve
ratio is currently
set at 10%; no interest is paid on reserve balances; and the averaging
period for computing reserves is 14 days. These rules are by no
means
typical among central banks. Indeed the trend among leading
industrial
nations has been toward zero reserve systems.
A Zero Reserve System
As an example, Canada imposes no
minimum reserve
on its banks. Its central bank, the Bank of Canada (BOC), freely
lends overnight at its so-called bank rate to ensure that
payment
orders between banks will clear. That sets an upper limit on
overnight
rates. It also pays interest on any clearing balances that banks
hold at the BOC at a rate 0.5 percentage point below the bank
rate.
That sets a floor on overnight rates. Volatility in the money
market
rate is effectively limited to within this operating range.
The BOC target rate is the
midpoint of the range.
In order to steer the overnight rate toward its target, the BOC
conducts
open market operations similar to those used by the Fed. To
compensate
for variations in clearing balances caused by federal government
inflows
and outflows, on a daily basis the BOC offers to buy or sell government
balances at the BOC on an auction basis to a select group of securities
dealers.
Is the U.S. Dollar a Special
Case?
Whether the U.S. would be better
served with a
zero reserve system is not a simple issue. An obvious advantage
would
be the removal of the tax on U.S. banks. That would improve their
competitive position world-wide. But the role of the U.S. dollar
as the primary world reserve currency must also be considered. At
the typically high level of U.S. dollar transactions, without an
adequate
cushion of reserves the number and size of bank overdrafts in Fed funds
could potentially cause serious problems.
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