This long post will discuss Regulations D and Q, their history, purpose and effect on
the banking system. It elaborates on modern monetary policy operations and recent
developments that have further removed the necessity for the anachronistic reserve
requirements established in Regulation D.
Regulations
D and Q were written to clearly demarcate between highly liquid transaction
accounts and less liquid savings accounts/ bank CDs. Their purpose was only
relevant under the gold standard. Under the gold standard, demand deposits (checking
account deposits and physical currency) could be exchanged for gold at a fixed
rate, whereas time deposits (savings accounts/CDs) could not.
Therefore the
banking system needed to control the flow between the percentage of the money
supply that was not convertible into gold (savings/CDs/bonds) and that which
was (checking/cash). Reg Q’s purpose was to allow banks only to pay interest on
non-convertible time deposits as a way to incentivize customers to put their
deposits into these accounts, and therefore limit the banking system’s exposure
to gold convertibility risk. To further delineate time and demand accounts, Reg
Q also prohibited the payment of interest on demand deposits until 2011.
Regulation
D then, required banks to hold a certain percentage of central bank money
(reserves or vault cash) against certain types of deposits. The classes of
reservable deposits has changed over time, and now only net transaction
accounts, (demand deposits/checking accounts) must be reserved against:
As an
another matter, Reg Q also capped the interest rate that banks could pay on
savings deposits, in order to prevent banks from “reaching for yield” (competing
for lower quality (more expensive) loans which would then have been used to
fund the higher rate paid to depositors. Another objective of capping interest
rates on deposits was to increase bank profits by limiting the competition for
deposits. Congress at the time felt that competition for deposits not only
reduced bank profits by raising interest expenses, but also have might cause
banks to acquire riskier assets with higher expected returns in attempts to
limit the erosion of their profits.
Congress
thought unpredictable movements of deposits among banking institutions in
response to interest rate competition made some banks vulnerable to failure.
Another related reason was that big money center banks could pay higher
interest rates for deposits than smaller banks, and thus could bid deposits
away from smaller regional banks. Larger banks frequently made more speculative
loans, such as for buying shares in the stock market. Lawmakers believed that
this competition for deposits misallocated financial resources away from
productive to speculative uses.
In
this way, Reg Q set a rough floor to lending quality. Reg Q’s blunt way of
preventing the “race to the bottom of underwriting quality” has now largely
been replaced by ability-to-repay standards from CFPB, and the capital
regulation system established by the Basel negotiations that began in 1988.
Regulation
D is written to limit the liquidity of savings accounts by only allowing a
certain amount of monthly withdrawals from time to demand accounts. Reg D also
imposes reserve requirements on depository institutions, which was intended as
a tool for managing the supply and price of bank money. These requirements
created a continuous demand for central bank money (reserves) above and beyond
what was needed for interbank payment settlement. Therefore by creating demand,
the Fed as the monopoly supplier of reserves could control the price of these
reserves and therefore the profitability of bank lending.
Before
1971 when the Federal Reserve’s own liabilities were convertible to gold, it
had an incentive to restrict the amount of its reserves that backed the credit
created by the banking system. So once this gold convertibility ended, the Fed slowly
began to ease its reserve lending facilities, since it no longer faced any convertibility
risk of its own. The 2003 amendments to Regulation A, which established the discount
window Primary Credit Facility as a “no questions asked” liquidity facility were
perhaps the first demonstration of this change.
Technically
however, the US left the gold standard in 1933, with only dollars in foreign
central banks convertible into gold during the Bretton Woods era which ended in
1971. Nevertheless, during this time and to some degree up to the present, the
Federal Reserve and economics profession have not fully understood the monetary
policy implications of the removal of the gold constraint.
Since the
Fed both imposes reserve requirements, and requires a positive end of day
balance in all Fedwire accounts, it has no choice to provide reserves to the
banking system, at its target rate. These reserves can be provided through open
market operations/Repos, through intraday credit through the Daylight Overdraft
facility, or finally through the discount window at a penalty rate. The demand
for these reserves is completely inelastic, much like a diver at the bottom of
the ocean needs an air supply. Not providing reserves at any price would result
in either a shortage of clearing balances or shortage of required reserves,
both of which would cause banks to bid up federal funds above the FOMC’s target
rate. Therefore, the Fed as the monopolist, has no choice but to provide reserves
in unlimited quantities at its target rate in order to defend the payment
system and ensure all reserve requirements can be met without bidding up the
federal funds rate.
If banks
were left on their own to obtain more reserves no amount of interbank lending
would be able to create the necessary reserves. Interbank lending changes the
location of the reserves but the amount of reserves in the entire banking
system remains the same. For example, suppose the total reserve requirement for
the banking system was $60 billion at the close of business today but only $55
billion of reserves were held by the entire banking system. Unless the Fed
provides the additional $5 billion in reserves through some facility, at least
one bank will fail to meet its reserve requirement. The Federal Reserve is, and
can only be, the follower, not the leader when it adjusts reserve balances in
the banking system. Perhaps the best example of the irrelevancy of reserve requirements
is that the Fed has not changed them since April 1992, the month when I was born! However, it is important
to keep in mind that the reserve requirement itself does not matter. If reserve
requirements are 10% or 100%, either way the Fed must provide reserves at its
target rate, as explained above.
Once Richard
Nixon ended what was left of the gold standard in 1971, neither of the restrictions
from Regulations D or Q became necessary. Since neither demand nor time
deposits were convertible to gold (or anything else at a fixed rate) after
1971, the banking system faced no convertibility risk and therefore did not
need to differentiate between deposit accounts or pay interest on time deposits
to reduce such risk. Other than issues relating to funding stability, from the
banks perspective checking and savings accounts became essentially the same.
The regulatory atmosphere finally caught up to this post-gold standard reality
in 2011 when the Federal Reserve repealed the last remaining part of Reg Q
which prevented banks from paying interest on demand deposits (see side note).
While Reg
D still exists, it is also less relevant than ever. The movement of much of the
deposit base to money market mutual funds, and allowing banks pay interest on
both checking and money market accounts, makes Reg D’s limit on time deposit
withdrawals largely irrelevant. Further, over the past several decades most
banks have become able to effectively avoid reserves requirements through the
use of sweep accounts. These sweep accounts are set up to automatically sweep
most of a banks reservable deposits (demand) into non-reservable deposits
(time) at the end of each 14-day reserve maintenance period, which reduces most
of a banks reservable deposits.
Sweeps
surged between 1995 and 2000. All charts from the Federal Reserve.
The
proliferation of sweep accounts has significantly reduced the percentage of
banks required to maintain reserve balances.
Many
depository institutions seek to meet most of their reserve requirements through
holding vault cash. Since vault cash is necessary for the everyday business of
meeting ATM/window withdrawals, banks figure they might as well use cash to
meet reserve requirements as well. So what banks do (or at least did before
IOR) is to meet as much of the reserve requirement through vault cash, and then adjust their reservable deposits so
the RR would be met by what they already had in cash. This is the opposite
of what the old fashioned, textbook version of reserve requirements would
suggest.
Required
reserve balances declined sharply in the 1990s as vault cash holdings rose.
Further,
the trillions of excess reserves in the banking system resulting from three
rounds of quantitative easing have left the banking system with enough reserves
to meet even these minimal requirements for decades into the future. Much of
the Federal Reserve’s own literature has supported both of these points.
All of this
all dramatically changed during the financial crisis of 2008. As the financial
crisis was worsening the Fed faced a conundrum. Through its various new/expanded
crisis- lending facilities (discount window, TALF, Corporate paper facility,
etc), the Fed was adding trillions of dollars of reserves to the banking
system, but it still had an overnight interest rate target above zero. Having
run out of unencumbered Treasury securities to sell off its portfolio in order
to drain these added reserves and support its interest rate target, the Fed
needed a new tool (during this time the Fed actually had to rely on Treasury to
conduct a special purpose bond offering with the sole purpose of draining
reserves, known as the Special Financing Program or SFP).
The
Financial Services Regulatory Relief Act of 2006 had authorized the Federal
Reserve Banks to pay interest on balances held by or on behalf of depository
institutions at Reserve Banks, subject to a rulemaking by the Board of Governors,
to be effective October 1, 2011. The effective date of this authority was
advanced to October 1, 2008 by the Emergency Economic Stabilization Act of
2008, and a rule amending Regulation D was finalized just a week later.
So in
October of 2008 the Fed gained the ability to pay interest on reserve balances,
a power which it previously did not have. This allowed the Fed to establish a
non-zero overnight interest rate without having to conduct any POMOs or Repos.
With the floor of interest rates now solidly in place, the Fed could continuing
lending emergency reserves into the banking system while simultaneously maintaining
a nonzero federal funds rate. Interest on Reserves (IOR) changed the game in
the federal funds market, and trading volume decreased significantly, by about
75%.
The 2008
changes to Regulation D effectively eliminated the need for reserve requirements.
Since the Fed now has the ability to pay interest on reserve balances, it can
“sterilize” a certain percentage of the monetary base simply by incentivizing
banks to move balances out of the federal funds market and into interest
bearing reserve accounts, known as “excess balances accounts”. It can also do
this in a more limited fashion with its new Term Deposit Facility (neither of these
facilities are available to the GSEs or FHLBs, so some trading in federal funds
remains, which is why the effective federal funds rate is slightly below the 25
basis points paid on reserves). In this way, the rate paid on reserve balances
serves as a floor to short term interest rates, and the rate charged for
institutions that borrow reserves from the Discount Window or through
overdrafts represents a ceiling on short term rates.
So with
this monetary incentive in place, there is no need to require banks to hold a certain
amount of reserves through regulation. Under the IOR system, no regulatory
requirement is needed to create a demand for reserves (although even with no
IOR banks would still need to hold reserves to meet payments).
This is
the way the Bank of Canada has implemented monetary policy since 1999. Canada
eliminated its reserve requirements in the 1990’s. Since then, it has set a
floor for the overnight rate through the interest it pays on settlement
(reserve) balances, known as Deposit Rate, and set the ceiling through the rate
it charges for overnight loans (discount window), known as Bank Rate. Deposit
rate and Bank rate are usually set 50 basis points apart, just like the IOR
rate and Discount rate are in the US. The overnight rate therefore trades in the
band between these two rates, and the Bank of Canada sets the midpoint of these
two rates as its target rate. This can be expressed as: Bank Rate>Target
Rate>Deposit Rate.
Concerns
that implementing monetary policy by increasing the rate paid on reserves represent
an increased cost to the government are unfounded. While it is true that the
interest the Fed pays on reserves is subtracted from what it would otherwise
remit to the Treasury, the Treasury ends up ‘paying’ either way. If the Fed
were to raise interest rates by selling off part of its Treasury portfolio, as
it has done in the past, then its earnings, and therefore remittances to the
Treasury, would decrease by about the same amount, and the yield on new
Treasury offerings would rise. (In fact, it is likely the case that banks end
up earning less under the IOR scenario, since the spread earned by Primary
Dealers banks acting as middlemen between Fed and Treasury operations was
likely higher than the current 25 basis points paid on all reserve balances).
Therefore the size of the Fed’s payments to the Treasury depend on the size of
its portfolio, not on the method used to raise interest rates. Either way, the
Federal Reserve’s earnings represent a tax on the economy, since the dollars
that it earns and remits to the Treasury would have otherwise remained in the
economy and distributed to savers, bondholders, or bank shareholders.
QE merely
represent a swap of governmental assets. When the FRBNY purchases Treasury and
Agency securities, is removes the Treasury/agency liability and replaces it
with its own liability (reserves). Deposits merely shift from securities
accounts at the Fed (saving) to reserve accounts at the Fed (checking). This is
identical to moving money from a savings account to a checking account. Concerns
that this rise in reserve balances could lead to inflation stem from a misunderstanding
of the post gold standard banking system. Since the start of QE, many lawmakers
and banking analysts have express concern that this increase in reserves will
lead to an explosion in new money creation through bank lending ,that could put
upward pressure on prices (needless to say, these people have been completely
wrong.) However, even before QE, as described above, the Fed, as the monopolist
of reserves, had no choice but to provide reserves to the banking system in
unlimited quantities, at its target rate. Now, as before, the Fed can only
influence the marginal cost/profitability of making a loan, not a bank’s
ability to do so. Bank lending is not constrained by any quantity of
reserves; it is the price of reserves that influence the marginal cost of
making a loan.
When banks
make loans, they are not “loaning out reserves” as is often portrayed. Reserves
are simply a liability of the central bank that can only exist in central banks
accounts, known as reserve accounts. Reserves cannot be lent “out”, or leave
the banking system (except as withdrawals of physical currency, which is not a
matter of monetary policy). In reality, banks create credit, which Reg D then requires
to be backed by a certain amount of central bank money; they do not “lend out”
anything. The textbook money multiplier model only applies to countries on a
fixed exchange rate where the central bank itself faces a convertibility
risk. In most countries with floating currencies, the money multiplier model
does not apply, as the Bank of England demonstrated in this paper and video last
year. Most of these countries have appropriately eliminated reserve
requirements after recognizing that they are no longer necessary.
During the “bubble” of the 2000’s when ostensibly too much lending was
going on, there were only a few billion of excess reserves in the banking system.
Now with $2.5 trillion of excess reserves, there is arguably “not enough”
lending going on. Clearly there is no correlation between quantity of reserves
and lending. It’s about marginal price, not quantity.
Bank lending
merely represents the creation of a new demand deposit balance for the borrower
(the banks liability) and a corresponding creation of a new bank asset of equal
value (the borrower’s liability). This is accomplished through simple
dual-entry accounting, and done completely independently of a bank’s reserve
position. Loan officers do not have to check with the CFO to see if they “have
the money” to make a loan! Once the borrower pays back the loan, both the bank’s
liability and the bank’s asset cease to exist, wiping out both sides of the
balance sheet. Therefore, eliminating Regulation D’s reserve requirements (as
was done in Canada many years ago) will have no tangible effect on bank
lending, economic growth, or inflation.
In any
case, the Federal Reserve cannot control the money supply, as the failed efforts of the monetarists in previous decades has demonstrated. The money multiplier is simply the ratio of the broad money supply to the
monetary base (mm = M/MB). Changes in the money supply cause changes in the
monetary base, not vice versa. The money multiplier is more accurately thought
of as a divisor (MB = M/mm). Failure to recognize the fallacy of the
money-multiplier model has led even some of the most well- respected experts
astray. The inelastic nature of the demand for bank reserves leaves the Fed
no control over the quantity of money. The Fed controls only the price,
which has not been changed by QE or IOR, and would not be changed by
eliminating reserve requirements.
---
Side note:
now that banks are allowed to pay interest on checking deposits, theory
indicates that checking account balances at banks would rise, since they no
longer represent a lost interest opportunity to the depositor. However, an
increase in checking account balances also means an increase in demand deposits,
which banks have to hold reserves against. Normally, an increase in reservable
deposits (in absence of sweeps of course) would constitute a larger “tax” on
the bank, since holding more unremunerated reserves would impose a marginal
cost to the bank. However, now that the Fed pays interest on both required and
excess reserves, the higher cost of holding more reserves against larger
checking account balances can be mitigated.
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