Are U.S. Reserve Requirements Still Binding? (Session 1: The Reserves Market)

I. INTRODUCTION The Federal Reserve requires U.S. commercial banks and other depository institutions to hold a minimum level of reserves in proportion to certain liabilities. On occasion, the central bank has reduced reserve requirements--such as in 1990, when requirements on large time deposits were dropped, and in 1992, when requirements on transaction accounts were reduced. In addition, more and more banks since 1994 have used computer technologies that temporarily "sweep" deposits from one type of account to another, thereby reducing required reserve levels. To provide customers with payments-related services, banks hold assets in two forms that also qualify as reserves: vault cash and balances deposited in Federal Reserve accounts. Such assets earn no interest when they meet reserve requirements, and traditionally the requirements have led banks to hold greater amounts of these nonearning assets than were optimal for business purposes. Reserve requirement reductions and deposit sweeping have allowed banks to lower such incremental costs. (1) After the elimination of reserve requirements on nonpersonal time deposits and eurocurrency liabilities in 1990, the federal funds market experienced a significant surge in volatility. This occurrence, coupled with the growth in retail sweeps in the late 1990s, has raised concerns that the continued decline in reserve balances would again destabilize the federal funds rate, thereby increasing the financing costs of borrowing banks and dealers. Despite the sharp drop in reserve balances, however, the effect on the overnight markets has been negligible, because at the same time banks have increased their reliance on Federal Reserve clearing balances and implemented more sophisticated information technologies (Clouse and Elmendorf 1997; Bennett and Hilton 1997). Banks "unbound" by reserve requirements are also less likely to be concerned with settlement day adjustments at the end of the maintenance period. Thus, the growing number of unbound banks may actually have helped diminish volatility in the federal funds market. Nevertheless, retail sweep programs are an inefficient and costly way to avoid reserve regulations. The proliferation of these programs therefore underscores the need for reform. One approach, currently in place in several industrialized countries, is the use of an operating procedure without explicit reserve requirements (see Borio [1997] and Woodford [2000]). The current focus in the United States, however, is more predisposed to modifying existing practices to alleviate the need to work around reserve requirements. As part of this initiative, Congress approved a bill in April 2001 that would authorize the Fed to pay interest on Federal Reserve account balances two years after the bill's enactment. (2) In this paper, we offer new statistical evidence indicating that reserve requirements have declined significantly in effectiveness, in the sense that they no longer appear to be as important a binding constraint on banks' holdings of assets that qualify as reserves. After reviewing definitions and concepts, we look at the trends indicating that banks have been successful in operating with significantly lower amounts of non-interest-bearing reserve assets. We also show that the periodic effects in the federal funds market associated with reserve requirements appear to be greatly reduced. Moreover, partly because of the growth of automated teller machines (ATMs), more banks have been able to fulfill their requirements entirely with vault cash. We present an econometric analysis showing that vault cash holdings have become linked more significantly to market interest rates, a finding consistent with the theoretical prediction that banks would tighten cash inventory management techniques in the absence of binding reserve requirements. II. BANK RESERVES: A REVIEW Most banks' marginal reserve requirements are 10 percent of demand and checking deposits. …