Comparing Full Reserve to Zero Reserve Banking
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William Hummel
May 28, 2012, 1:14:42 PM5/28/12
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Regardless of the required reserve ratio, a bank can lend only to the extent that it acquires reserves sufficient to cover its loans. As long as the Fed targets the interbank lending rate rather than the quantity of money, the required reserve ratio appears to be of little significance.
Common Features
A startup bank must use its own capital to open a reserve account at the Fed.
Thereafter the Fed provides additional reserves in the aggregate via OMO at no cost to banks. [Thus reserves are not a tax on banks, as often claimed.]
An interbank lending market is needed to rebalance reserves among banks.
A bank must have enough free reserves to cover a loan on the day it lends.
A bank increases aggregate transaction deposits when it lends
An increase in transaction deposits increases demand for reserves which the Fed must supply.
A bank can acquire the reserves needed to cover its lending in any of the following ways: (1) Borrow from the Fed, (2) Borrow from another bank, (3) Borrow from a non-bank, (4) Induce transaction account holders to move funds into savings or time deposits, (5) Sell assets in the open market, (6) Sell additional bank shares to investors.
Differences
ZRB: Has no mandatory reserve requirement.
FRB: Must hold mandatory reserves equal to transaction deposits at all times.
ZRB: Banks have no requirement to report on transaction deposits versus reserves.
FRB: Banks must report daily on their transaction deposits versus mandatory reserve status.
ZRB: A new transaction deposit brings a bank equal reserves which could be used to cover a new loan.
FRB: A new transaction deposit brings a bank no free reserves, only mandatory reserves.
Joe Leote
May 30, 2012, 11:29:09 AM5/30/12
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William,
I agree with you that reserves do not have an absolute cost to banks in aggregate, however, each bank sees the reserves as an idle asset representing an opportunity cost in an expanding investment economy, just as each nonbank sees holdings of zero return money as an opportunity cost in an expanding investment economy.
When bank credit assets are performing well, and collateral values are rising in general, each bank would prefer to hold more bank credit and less reserves in a risk-on play, to increase profits via a leveraged balance sheet. So even though Fed provides the reserves for free, each bank tries to hold less reserves and more bank credit then the next bank, which merely forces the reserves to circulate and pile up at the less aggressive growth banks, I imagine, and be loaned back to the aggressive growth banks via Fed funds and other reserve conservation methods.
Joe
I agree with you that reserves do not have an absolute cost to banks in aggregate, however, each bank sees the reserves as an idle asset representing an opportunity cost in an expanding investment economy, just as each nonbank sees holdings of zero return money as an opportunity cost in an expanding investment economy.
When bank credit assets are performing well, and collateral values are rising in general, each bank would prefer to hold more bank credit and less reserves in a risk-on play, to increase profits via a leveraged balance sheet. So even though Fed provides the reserves for free, each bank tries to hold less reserves and more bank credit then the next bank, which merely forces the reserves to circulate and pile up at the less aggressive growth banks, I imagine, and be loaned back to the aggressive growth banks via Fed funds and other reserve conservation methods.
Joe
William Hummel
May 30, 2012, 1:49:13 PM5/30/12
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Joe,
I agree that banks see reserves as idle assets representing an opportunity
cost, but one must make a distinction between mandatory and free
reserves. In effect, mandatory reserves belong to depositors, and free
reserves to banks. An increase in the required reserve ratio would have no
effect on free reserves, it would only increase mandatory reserves. The Fed
would create all of the additional reserves required to cover the increase in
mandatory reserves at no cost to banks. It would do so by simply converting
securities held by the public into money, i.e. new transaction deposits.
William
Joe Leote
May 30, 2012, 3:05:50 PM5/30/12
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William,
Below you say the required (mandatory) reserve ratio appears to be of little significance as long as Fed targets the interbank lending rate rather than the quantity of money. To me this means banks can always get free reserves from any level of mandatory reserves. Fed would have to conduct OMO at higher volumes, and full reserve banking has no more restriction on the expansion of bank balance sheets than does fractional reserve banking, the primary restriction being Fed control over the interbank rate of interest.
The idea that mandatory reserves belong to depositors causes me to wonder. I regard mandatory reserves as a secure form of bank assets held as Fed liabilities, just as Treasury securities are secure bank assets held as Treasury liabilities. Thus reserves are part of the capital adequacy. Depositors as general bank creditors would have claim on the capital before equity owners, so I suppose the mandatory reserves would be regarded as a portion of bank capital rather than straight up assets of depositors. Increasing mandatory reserve levels, then, is a change in the composition of required bank capital, and has no other major impact on the banking system, if Fed targets the interbank rate of interest, except Fed must act in greater volume to influence the Fed funds rate. I am just thinking out loud to perhaps get your feedback on my initial thoughts ...
Joe
Below you say the required (mandatory) reserve ratio appears to be of little significance as long as Fed targets the interbank lending rate rather than the quantity of money. To me this means banks can always get free reserves from any level of mandatory reserves. Fed would have to conduct OMO at higher volumes, and full reserve banking has no more restriction on the expansion of bank balance sheets than does fractional reserve banking, the primary restriction being Fed control over the interbank rate of interest.
The idea that mandatory reserves belong to depositors causes me to wonder. I regard mandatory reserves as a secure form of bank assets held as Fed liabilities, just as Treasury securities are secure bank assets held as Treasury liabilities. Thus reserves are part of the capital adequacy. Depositors as general bank creditors would have claim on the capital before equity owners, so I suppose the mandatory reserves would be regarded as a portion of bank capital rather than straight up assets of depositors. Increasing mandatory reserve levels, then, is a change in the composition of required bank capital, and has no other major impact on the banking system, if Fed targets the interbank rate of interest, except Fed must act in greater volume to influence the Fed funds rate. I am just thinking out loud to perhaps get your feedback on my initial thoughts ...
Joe
William Hummel
May 30, 2012, 5:31:45 PM5/30/12
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Joe,
When I said the reserve ratio requirement has little significance, it was
in this context of all the common features I listed and the
fact that banks must acquire free reserves to lend, regardless of the
reserve ratio requirement. The only significant difference I can see is that in
a fractional reserve system banks can tap into mandatory reserves if their
average holding over a 14-day period meets the requirement, as in the US. That
provides a degree of freedom in issuing loans that would not exist in a full
reserve system. In the latter case reserves must continually cover transaction
deposits.
I said that in effect mandatory reserves belong to depositors,
which is not the same as saying they legally belong to them.
However they literally belong to depositors in a transition from a full
reserve system to a single national depository system. Mandatory reserves become
transaction deposits in the accounts of the former bank depositors and free
reserves become transaction deposits in the accounts of banks.
I agree with your conclusion that the Fed OMO must deal in larger
volume as the reserve ratio requirement increases if it targets the interbank
lending rate. But I don't regard the increase in required reserves as a burden
on banks since banks get the added reserves at no cost. Aggregate balance sheets
of banks increase when the Fed increases bank reserves, but bank
capital remains unchanged. I think US banks have fought the existing
10% reserve ratio with a phony argument about its being a tax which makes them
less competitive. Or perhaps they are simply misinformed.
William
Joe Leote
May 31, 2012, 12:22:42 PM5/31/12
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William,
This is an 8 page paper on reserves that you may find of interest:
Interest on Reserves and Monetary Policy (unpublished version):
http://www.newyorkfed.org/research/epr/02v08n1/0205good.pdf
it cites references that argue required reserves are a tax on banks, and claims that reserves are free of storage cost as Fed liabilities, if the bankers argue reserves are a tax it appears they have been aided by economists such as M. Friedman and others.
If I were a banker, my total assets:
Earning Assets = (R x iR) + (RL*iRL) + (BC*iBC)
include reserves R, reserve loans RL, and bank credit BC, each earns an average interest rate iR, iRL, and iBC, respectively, so to earn more on total assets if iR = 0, I want to hold more RL and BC and less R, as a matter of business profit motive, I do not see reserves as a "free gift" from Fed even though this is true in aggregate, it is not true regarding my profit motives as a micro manager (I am only restating the position because I expect this banker psychology to endure as a persistent feature of the way firm managers tend to view the world, not because I disagree with your logic about the system in aggregate).
Joe
This is an 8 page paper on reserves that you may find of interest:
Interest on Reserves and Monetary Policy (unpublished version):
http://www.newyorkfed.org/research/epr/02v08n1/0205good.pdf
it cites references that argue required reserves are a tax on banks, and claims that reserves are free of storage cost as Fed liabilities, if the bankers argue reserves are a tax it appears they have been aided by economists such as M. Friedman and others.
If I were a banker, my total assets:
Earning Assets = (R x iR) + (RL*iRL) + (BC*iBC)
include reserves R, reserve loans RL, and bank credit BC, each earns an average interest rate iR, iRL, and iBC, respectively, so to earn more on total assets if iR = 0, I want to hold more RL and BC and less R, as a matter of business profit motive, I do not see reserves as a "free gift" from Fed even though this is true in aggregate, it is not true regarding my profit motives as a micro manager (I am only restating the position because I expect this banker psychology to endure as a persistent feature of the way firm managers tend to view the world, not because I disagree with your logic about the system in aggregate).
Joe
William Hummel
May 31, 2012, 1:57:55 PM5/31/12
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Joe,
Thanks for the link to Goodfriend's paper. I found it interesting but
a fairly difficult read because there is lot of jargon whose precise
meaning I had to guess at. Regarding the issue of reserves as a tax on
banks, I didn't see any rationale supporting the claim. Friedman was smart but
not infallible
Every bank must acquire the free reserves it needs to cover it loans.
That's true whether there is a mandatory reserve requirement or not. Do you
believe US banks with a 10% reserve ratio requirement operate at a
disadvantage relative to say Canadian banks which have no reserve
requirement?
Joe Leote
May 31, 2012, 3:17:36 PM5/31/12
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William,
I don't have time to read the economic literature on the idea that required reserves are a hidden tax on banks, but I assume more than one fallible economist has made a reasonable argument on the matter.
It appears there are too many factors in a comparative study of banks across international lines to infer that reserve requirements alone play a dominant role in relative profitability. Perhaps you are correct and reserves play no role at all since each central bank while targeting an interbank interest rate essentially subsidizes its domestic banks and removes the "tax." I really do not know.
If regulations and rules exist to restrict bank balance sheet growth in the interest of greater economic stability, I nonetheless expect advocates of "financial freedom" led by bankers wishing to make a fortune from bank balance sheet expansion, to take the other side of the argument in the landscape of political-economic debate.
Joe
I don't have time to read the economic literature on the idea that required reserves are a hidden tax on banks, but I assume more than one fallible economist has made a reasonable argument on the matter.
It appears there are too many factors in a comparative study of banks across international lines to infer that reserve requirements alone play a dominant role in relative profitability. Perhaps you are correct and reserves play no role at all since each central bank while targeting an interbank interest rate essentially subsidizes its domestic banks and removes the "tax." I really do not know.
If regulations and rules exist to restrict bank balance sheet growth in the interest of greater economic stability, I nonetheless expect advocates of "financial freedom" led by bankers wishing to make a fortune from bank balance sheet expansion, to take the other side of the argument in the landscape of political-economic debate.
Joe
Jean Erick
May 31, 2012, 2:06:25 PM5/31/12
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Aren't mandatory reserves
a percentage of deposits? Therefore not a part of the banks capital.
Bank start ups excepted.
But then, it's according to your definition of bank
capital.
James
Joe Leote
Jun 1, 2012, 12:31:27 PM6/1/12
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James,
So what if mandatory reserves are a percentage of deposits? Reserves are bank assets, and deposits are bank liabilities.
If the bank goes insolvent the most secure of its assets are Fed liabilities (reserve balances and vault cash) and Treasury liabilities (Treasury securities). Whatever the measure of bank capital, the most secure assets, which are least subject to default, get 100% weighting toward bank capital.
Joe
So what if mandatory reserves are a percentage of deposits? Reserves are bank assets, and deposits are bank liabilities.
If the bank goes insolvent the most secure of its assets are Fed liabilities (reserve balances and vault cash) and Treasury liabilities (Treasury securities). Whatever the measure of bank capital, the most secure assets, which are least subject to default, get 100% weighting toward bank capital.
Joe
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