The financial markets shook with fear last month when the minutes of the US Federal Reserve’s meeting suggested the central bank may reconsider the costs of pumping nearly $1.7tn of excess reserves into the banking system. Of particular concern to Federal Open Market Committee members is the inflationary potential of these reserves if the banks turn them into loans and deposits.
Before the financial crisis, banks held few reserves in excess of their requirements. This allowed the Fed to closely control the level of deposits that are extended when banks create loans. But today’s huge supply of excess reserves means financial institutions can create trillions of dollars of loans and deposits, which will be highly inflationary.
To eliminate these excess reserves, the Fed would have to sell more than half of its nearly $3tn portfolio of Treasury bonds and mortgage-backed securities. Since the Fed has indicated that reversing its quantitative easing would only be done in a rapidly improving economic environment, which normally puts pressure on bond prices, further bond sales from the central bank could be destabilising to the financial markets.
Fortunately, there is a solution to the Fed’s exit problem that does not involve selling securities. It employs one of the Fed’s oldest policy tools: raising reserve requirements.
All textbooks on money and banking highlight the three principal policy options open to central banks: discount lending, open market operations, and reserve requirements. Since the financial crisis broke, the Fed has vigorously used the first two.
Massive discount lending to banks following the Lehman collapse prevented a devastating run on banks. Then huge open market purchases of Treasury and mortgage-backed securities provided the financial system with much-needed liquidity. But the Fed has not altered reserve requirements in more than 20 years and has not raised any reserve ratio on any deposit in almost four decades.
The decline in the use of reserve requirements is startling. Under pressure from the banks to keep costs down, required reserves at the Fed had withered to only $40bn before the financial crisis broke, equal to less than 0.5 per cent of the banks’ liabilities, far below the ceilings set by the Monetary Control Act of 1980.
This legislation allowed the Fed to set a reserve ratio up to 18 per cent on transactions balances and 9 per cent on time deposits. Additionally, the MCA allows the Fed to impose any reserve ratio it wishes on any liability of the banking industry for a period of up to one year.
The Fed’s Flow of Funds Account indicates that total deposits in financial institutions were $10.6tn at the end of 2012. This implies that a 15 per cent reserve requirement on deposits would absorb almost all the excess reserves now in the banks. To prevent banks from evading reserve requirements by issuing other, non-reserved liabilities, the Monetary Control Act also gave the Fed powers to impose reserves on any non-deposit funding source.
Data from the Fed show that most FOMC members expect the long-run Fed Funds target to be about 4 per cent, which would imply that the Fed would pay a 2 per cent rate on reserves under this policy. Given $1.7tn dollars of reserves, these payments would amount to a $34bn cost to the Fed, which is less than half of the $77bn that the central bank earned in 2012. This means that after paying interest on bank reserves, Fed profits, which are remitted to the US Treasury, would still exceed profit levels that prevailed before the financial crisis.
Another attractive feature of higher reserve ratios is that it allows the government to modify and in some cases eliminate the liquidity and capital ratios dictated by new Basel III banking regulations. Reserves are deposits at the Fed that can be turned into currency on demand and as such are the world’s most liquid asset. The higher reserve levels achieved by this policy will satisfy many of the liquidity requirements in the Basel Agreement.
The bottom line is that by increasing required reserves and bringing the Fed’s third policy tool out from hibernation, the Fed’s exit strategy can be made far easier. And since these reserves satisfy many of the Basel III provisions, this policy can be a win-win for the Fed, the banking industry and the US economy.
Jeremy J. Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania