Application Why Have Reserve Requirements Been Declining Worldwide

In recent years, central banks in many countries in the world have been reducing or eliminating their reserve requirements. In the United States, the Federal Reserve eliminated reserve requirements on time deposits in December 1990 and lowered reserve requirements on checkable deposits from 12% to 10% in April 1992. As a result, the majority of U.S. depository institutions—but not the largest ones with the bulk of deposits—find that reserve requirements are not binding: In order to service their depositors, many depository institutions need to keep sufficient vault cash on hand (which counts toward meeting reserve requirements) that they more than meet reserve requirements voluntarily. Canada has gone a step further: Financial market legislation taking effect in June 1992 eliminated all reserve requirements over a two-year period. The central banks of Switzerland, New Zealand, and Australia have also eliminated reserve requirements entirely. What explains the downward trend for reserve requirements in most countries?

You may recall from Chapter 9 that reserve requirements act as a tax on banks. Because central banks typically do not pay interest on reserves, the bank earns nothing on them and loses the interest that could have been earned if the bank held loans instead. The cost imposed on banks from reserve requirements means that banks, in effect, have a higher cost of funds than intermediaries not subject to reserve requirements, making them less competitive. We have already seen in Chapter 10 that additional market forces have been making banks less competitive, weakening the health of banking systems throughout the world. Central banks have thus been reducing reserve requirements to make banks more competitive and stronger.6 The Federal Reserve was explicit about this rationale for its April 1992 reduction when it announced it on February 18, 1992, stating in its press release that the reduction "will reduce funding costs for depositories and strengthen their balance sheets. Over time, it is expected that most of these cost savings will be passed on to depositors and borrowers."

Application The Channel/Corridor System for Setting Interest Rates in Other Countries

The fall in reserve requirements has elicited the concern that if the demand for reserves falls to zero, then a central bank may not be able to exercise control over interest rates.7 However, the so-called channel or corridor system for conducting monetary policy—which has been adopted by Canada,

6Many economists believe that the Fed should pay market interest rates on reserves, another suggestion for dealing with this problem.

7See Benjamin Friedman, "The Future of Monetary Policy: The Central Bank as an Army with Only a Signal Corps?" International Finance 2 (1999), pp. 321-338, and the rest of the symposium on this topic in the same journal.

Australia, and New Zealand, all of which have eliminated reserve requirements—shows that central banks can continue to effectively set overnight, interbank interest rates like the federal funds rate. How the channel/corridor system works is illustrated by Figure 6, which describes the market for reserves along the lines discussed at the beginning of this chapter.

In the channel/corridor system, the central bank sets up a standing lending facility, like the one currently in place in the United States and in most industrialized countries, in which the central bank stands ready to lend overnight any amount banks ask for at a fixed interest rate, il. This standing lending facility is commonly called a lombard facility and the interest rate charged on these loans is often called a lombard rate. (This name comes from Lombardy, a region in northern Italy that was an important center of banking in the middle ages.) As we saw at the beginning of the chapter, with a standing lending facility, the central bank does not limit the amount of borrowing by banks, but always stands ready to supply any amount the banks want at the lending rate il. Thus the quantity of reserves supplied is flat (infinitely elastic) at il as shown in Figure 6, because if the overnight interest rate, denoted by iff, begins to rise above il, banks would just keep borrowing discount loans indefinitely.

In the channel/corridor system the central bank sets up another standing facility that pays banks a fixed interest rate ir on any reserves (deposits) they would like to keep at the central bank. The quantity of reserves supplied is also flat at ir, because if the overnight rate begins to fall below this rate, banks would not lend in the overnight market. Instead they would keep increasing the amount of their deposits in the central bank (effectively lending to the central bank), and would thereby keep lowering the quantity of reserves the central bank is supplying. In between ir and il, the quantity of reserves supplied equals nonborrowed reserves Rn, which are determined by open market operations. Nonborrowed reserves are set to zero if the demand for reserves is also expected to be zero. The supply curve for reserves Rs is thus the step function depicted in Figure 6.

The demand curve for reserves Rd has the usual downward slope. As we can see in Figure 6, when the demand curve shifts to the left to R1 the overnight interest rate never falls below ir, while if the demand curve shifts to the right to R2, the overnight rate never rises above il. Thus the channel/ corridor system enables the central bank to keep the overnight interest rate in between the narrow channel/corridor with an upper limit of il and lower limit of ir. In Canada, Australia, and New Zealand the lending rate il is set 25 basis points (0.25 percentage points) above the announced target rate, while the interest rate paid on reserves kept at the central bank is set at 25 basis points below the target. More in-depth analysis shows that banks will set the demand for reserves so that the demand curve is expected to intersect the supply curve at the announced target overnight rate of if*f, with the result that deviations from the announced target are fairly small.8

8See Michael Woodford, "Monetary Policy in the Information Economy," in Symposium on Economic Policy for the Information Economy (Federal Reserve Bank of Kansas City: 2001), pp. 297-370.

FIGURE 6 The Channel/ Corridor System for Setting Interest Rates

In the channel/corridor system standing facilities result in a step function supply curve, Rs. Then if the demand curve shifts between R1 and R', the overnight interest rate iffalways remains between ir and il.

FIGURE 6 The Channel/ Corridor System for Setting Interest Rates

In the channel/corridor system standing facilities result in a step function supply curve, Rs. Then if the demand curve shifts between R1 and R', the overnight interest rate iffalways remains between ir and il.

Rn Quantity of

Reserves, R

Rn Quantity of

Reserves, R

The important point of this analysis is that the channel/corridor approach enables the central bank to set the overnight policy rate, whatever the demand for reserves, including zero demand. Thus in the future, continuing declines in the demand for reserves may eventually lead central banks to follow in the footsteps of the central banks of Canada, Australia, and New Zealand, and to adopt the channel/corridor system for conducting monetary policy.

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  • sinit
    Why reserves have been declining?
    2 months ago

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