In the traditional textbook model of banking, the reserve requirement plays a vitally important role in determining the money supply. Since the reserve requirement dictates the amount of cash that banks must hold against customer deposits, it determines the extent to which deposits can be ‘multiplied’ up into new money. A higher reserve requirement forces banks to hold more cash, while a lower requirement permits more loan-making activity. Under this model, a reserve requirement of zero would be a calamitous event, leading to a potentially infinite creation of money and hyperinflation. The fact that disaster did not occur, then, when the American reserve requirement was set to zero in March 2020, is an indication of the difference between banking in theory and banking in practice.
Although the textbook model is still taught to burgeoning economists, it was never an accurate description of the banking system, and has become even more antiquated since the Global Financial Crisis of 2008. Since the formation of the federal funds market in the 1920s, banks have never been restricted by their level of reserves when making lending decisions. If a bank did not have enough required reserves to allow them to make a new loan, they could simply borrow the reserves from another bank. Banks were therefore limited only by the interest cost of borrowing reserves.
This interest rate was determined by the supply of reserves in the system, which was controlled by the Fed in pursuit of a target rate. The Fed had to be responsive, and supply the system with new reserves as demand for reserves rose. If they did not, the interest rate would rise higher than the Fed’s target. This mechanism explains why the Fed always supplied new reserves to the system as needed, and why the lending decisions of banks depended only on the profitability of new loans.
The original intent of reserve requirements was to ensure that banks had sufficient cash to avoid the panic of bank runs. Since reserves can be converted into currency, the early Fed hoped that making banks maintain a healthy amount of liquidity would head off the initial doubts that ultimately spiral into mass withdrawals. The collapse of many banks during the Great Depression, though, proved reserve requirements ineffectual at this task. The reserve requirement was repurposed as a tool to help the Fed estimate the demand for reserves in the banking system, and thus make maintaining the target federal funds rate easier.
Since 2008, however, central banking has entered a new era that no longer has a need for reserve requirements. The Global Financial Crisis saw the Fed, and many other central banks, purchase huge amounts of financial assets in an attempt to support markets. The Fed bought these assets with reserves, leaving commercial banks with reserve balances far in excess of the required level. Prior to 2008, the total level of reserves in the banking system figured at a little over $40 billion. As of August 2022, total reserves now stand at $3.3 trillion. As the banking system has shifted from a reserve-scarce regime to a reserve-abundant one, the reserve requirement has become obsolete.
Still, the reserve requirement could have been maintained as a benign feature of the banking system, existing to placate politicians who fret about bank discipline. Due to a quirk in regulations, however, the reserve requirement can actually be harmful during market dislocations. Banks are required to maintain a stock of high-quality assets to ensure they have sufficient liquidity in a crisis. Failure to keep a certain amount of these assets can result in harsh regulatory action. Required reserves, however, are exempt from counting as high-quality assets, since they are ‘required’ to be maintained by banks even during a crisis.
As a regulatory position, this is illogical and foolish, since one of the purposes of required reserves has always been to serve as a source of liquidity during a crisis. During the 2020 market panic, when bank liquidity became a real concern, the Fed recognized that required reserves were a stock of high-quality assets being excluded from liquidity coverage requirements for no good reason. In March of that year, the Fed finally dropped the reserve requirement to zero, allowing all bank reserves to count as high-quality assets. This significantly expanded the market-making ability of banks and helped restore market confidence.
Although it took a financial crisis for the Fed to finally bury the reserve requirement, the tool has been dead since 2008. In a reserve-abundant regime, the Fed controls interest rates through its reverse repurchase facility (as a floor) and by paying interest on bank reserves (as a ceiling). Therefore, tools used to estimate reserve demand, such as the reserve requirement, are no longer useful. In fact, due to a strange regulatory rule, the reserve requirement turned out to be quite harmful. The Fed putting the reserve requirement to rest is indicative of the sea change in the practice of central banking over the past two decades.
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