Modern Money Mechanics

A Workbook on Bank Reserves and Deposit Expansion

Changes in Reserve Requirements

Thus far we have described transactions that affect the volume of bank reserves and the impact these transactions have upon the capacity of the banks to expand their assets and deposits. It is also possible to influence deposit expansion or contraction by changing the required minimum ratio of reserves to deposits.

The authority to vary required reserve percentages for banks that were members of the Federal Reserve System (member banks) was first granted by Congress to the Federal Reserve Board of Governors in 1933. The ranges within which this authority can be exercised have been changed several times, most recently in the Monetary Control Act of 1980, which provided for the establishment a reserve requirements that apply uniformly to all depository institutions. The 1980 statute established the following limits:

On transaction accounts
first $25 million 3%
above $25 million 8% to 14%
On non personal time deposits 0% to 9%

The 1980 law initially set the requirement against transaction accounts over $25 million at 12 percent and that against non personal time deposits at 3 percent. The initial $25 million "low reserve tranche" was indexed to changed each year in line with 80 percent of the growth in transaction accounts at all depository institutions. (For example, the low reserve tranche was increased from $41.1 million for 1991 to $42.2 million for 1992.) In addition, reserve requirements can be imposed on certain non deposit sources of funds, such as Eurocurrency liabilities. (Initially the Board set a 3 percent requirement on Eurocurrency liabilities.)

The Garn-St. Germain Act of 1982 modified these provisions somewhat by exempting from reserve requirements the first $2 million of total reservable liabilities at each depository institution. Similar to the low reserve tranche adjustment for transaction accounts, the $2 million "reservable" liabilities exemption amount was indexed to 80 percent of annual increases in total reservable liabilities. (For example, the exemption amount was increased from $3.4 million for 1991 to $3.6 million for 1992.)

The Federal Reserve Board is authorized to change, at its discretion, the percentage requirements on transaction accounts above the low reserve tranche and on non personal time deposits within the ranges indicated above. In addition, the Board may impose differing reserve requirements on non personal time deposits based on the maturity of the deposit. (The Board initially imposed the 3 percent non personal time deposit requirement only on such deposits with original maturities of under four years.)

During the phase-in period, which ended in 1984 for most member banks and in 1987 for most nonmember institutions, requirements changed according to a predetermined schedule without any action by the Federal Reserve Board. Apart from these legally prescribed changes, once the Monetary Control Act provisions were implemented in late 1980, the Board did not change any reserve requirement ratios until late 1990. (The original maturity break for requirements on non personal time deposits was shortened several times, once in 1982, and twice in 1983, in connection with actions taken to deregulate rates paid on deposits.) In December 1990, the Board reduced reserve requirements against non personal time deposits and Eurocurrency liabilities from 3 percent to zero. Effective in April 1992, the reserve requirement on transaction accounts above the low reserve tranche was lowered from 12 percent to 10 percent.

When reserve requirements are lowered, a portion of banks' existing holdings of required reserves becomes excess reserves and may be loaned or invested. For example, with a requirement of 10 percent, $10 of reserves would be required to support $100 of deposits. See illustration 30. But a reduction in the legal requirement to 8 percent would tie up only $8, freeing $2 out of each $10 of reserves for use in creating additional bank credit and deposits. See illustration 31.

An increase in reserve requirements, on the other hand, absorbs additional reserve funds, and banks which have no excess reserves must acquire reserves or reduce loans or investments to avoid a reserve deficiency. Thus an increase in the requirement from 10 percent to 12 percent would boost required reserves to $12 for each $100 of deposits. Assuming banks have no excess reserves, this would force them to liquidate assets until the reserve deficiency was eliminated, at which point deposits would be one-sixth less than before. See illustration 32.

Reserve Requirements and Monetary Policy

The power to change reserve requirements, like purchases and sales of securities by the Federal Reserve, is an instrument of monetary policy. Even a small change in requirements - say, one-half of one percentage point - can have a large and widespread impact. Other instruments of monetary policy have sometimes been used to cushion the initial impact of a reserve requirement change. Thus, the System may sell securities (or purchase less than otherwise would be appropriate) to absorb part of the reserves released by a cut in requirements.

It should be noted that in addition to their initial impact on excess reserves, changes in requirements alter the expansion power to every reserve dollar. Thus, such changes affect the leverage of all subsequent increases or decreases in reserves from any source. For this reason, changes in the total volume of bank reserves actually held between points in time when requirements differ do not provide an accurate indication of the Federal Reserve's policy actions.

Both reserve balances and vault cash are eligible to satisfy reserve requirements. To the extent some institutions normally hold vault cash to meet operating needs in amounts exceeding their required reserves, they are unlikely to be affected by any change in requirements.

The 1980 statute also provides that "under extraordinary circumstances" reserve requirements can be imposed at any level on any liability of depository institutions for as long as six months; and, if essential for the conduct of monetary policy, supplemental requirements up to 4 percent of transaction accounts can be imposed.

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30. Under a 10 percent reserve requirement, $10 of reserves are needed to support each $100 of deposits.

31. With a reduction in requirements from 10 percent to 8 percent, fewer reserves are required against the same volume of deposits so that excess reserves are created. These can be loaned or invested.

There is no change in the total amount of bank reserves.

32. With an increase in requirements from 10 percent to 12 percent, more reserves are required against the same volume of deposits. The resulting deficiencies must be covered by liquidation of loans or investments...

...because the total amount of bank reserves remains unchanged.

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