Required Clearing Balances by E.J

Home , Clearing (finance)

Required Clearing Balances by E.J. Stevens E.J. Stevens is an assistant vice president and economist at the Federal Reserve Bank of Cleve- land. The author thanks Cheryl L. Edwards for helpful comments on an earlier draft of this article and Ann Dombrosky for invaluable research assistance.

Introduction Bank to comply with the combined requirements. For each of these institutions, the conse- Few people realize that in addition to complying quences of modest account deficiencies or with a Federal Reserve System regulation for surpluses are reckoned on the basis of re- holding a required reserve balance, many banks quired clearing balance rules. Only if a bank simultaneously meet an additional requirement fails to meet any of its clearing balance require- to hold a clearing balance in their account at a ment does it face the familiar "discount rate Federal Reserve Bank. This clearing balance re- plus 2 percent" penalty for a required reserve quirement differs from the familiar reserve re- deficiency. Likewise, such a bank wastes sur- quirement in three significant ways. First, a bank's plus balances by earning no rate of return only agreement to meet the requirement is typically a if its actual balance exceeds its required bal- business decision, not a legal necessity. Second, ance by more than a preestablished margin. the amount of the requirement is mostly discre- Almost all analyses of bank reserve manage- tionary, not a fixed percentage of the bank's de- ment behavior focus entirely on reserve require- posit liabilities. And third, the rate of return on a ments, ignoring clearing balances because they clearing balance is about equal to the federal are a relatively recent innovation.2 Clearly, how- funds rate, not zero, although a bank can use the ever, an important set of banks now maintains earnings only to pay for services it buys from a balances at the Fed following a somewhat differ- Federal Reserve Bank. ent set of rules than they would if they held only About 5,000 banks now maintain required required reserve balances. Knowledge of these clearing balances, ranging from small retail de- rules is of more than accounting interest. For one positories with a $25,000 minimum requirement thing—contrary to most models of the banking to giant money center banks with clearing balance requirements of several hundred million • 1 For simplicity, I use the term banks to mean all depository institu- dollars.1 Forty-five percent of all required re- tions. serve balances and 85 percent of all required • 2 A good survey might start with Poole (1968) and include Coats clearing balances are held by banks that use a (1976), Spindt and Tarhan (1978), Friedman and Roberts (1983), Evanoff mixed deposit account at a Federal Reserve (1989), and Feinman (1993). FIGURE 1 Required Balances at Federal Reserve Banks

Billions of dollars 45 40 35 30 25 20 15 10 Required clearing 5 balances 0 _L 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 a. Required balances equal required reserve balances plus required clearing balances. SOURCE: Board of Governors of the Federal Reserve System.

system and of monetary policy implementation This article is intended primarily to describe — standard indicators of Federal Reserve policy, the little-known rules governing required clear- including total and excess reserves and the ing balances and to introduce some related monetary base, probably contain a growing issues. The first two sections include back- (albeit very small) component that effectively ground information about clearing balances has a positive rate of return. and a look at how a bank might manage a For another thing, banks seem to be substitut- combined required reserve and required clearing required clearing balances for required re- ing balance. More precise institutional details serve balances. In the aggregate, banks now hold are spelled out in the appendix. The third sec- about $33 billion of required balances at the Fed- tion outlines three areas in which issues war- eral Reserve, including $27 billion of required re- rant further investigation. One is the way in serve balances and $6 billion of required clearing which measures of bank reserves and the mon- balances. Required reserve balances have de- etary base have come to include an interest- clined about $6 billion over the past three years, bearing component as a result of required while required clearing balances have almost clearing balances. The next points to ambigu- tripled (see figure I).3 Although banks surely ity in explanations of the rapid growth of re- welcome lower reserve requirement taxes, the quired clearing balances. A third sketches Federal Reserve must deal with the payment sys- some related central banking concerns about tem risk and monetary policy implementation re- monetary policy implementation and payment percussions of a banking system operating on a service delivery. smaller cash deposit base. These repercussions may be muted, however, to the extent that banks replace required reserve balances with required I. Some Background clearing balances. The question, then, is why have required clearing balances grown so rapidly, The Depository Institutions Deregulation and and, more particularly, would further cuts in re- Monetary Control Act of 1980 extended coverage serve requirements be offset by further growth of of Federal Reserve System reserve requirements required clearing balances? from member banks to all depository institutions. At the same time, all depositories gained access • 3 The dollar volume of required clearing balances is reported as foot- to the Federal Reserve discount window and to note 3 in Factors Affecting Reserve Balances of Depository Institutions and Reserve Bank payment services. Services had to Condition Statement of F.R. Banks (Federal Reserve Release H.4.1), and as be priced at levels intended to recover their full part of the larger "service-related balances and adjustments" item in the data cost of provision, including an allowance for the table "Reserve and Depository Institutions and Reserve Bank Credit" (Federal Reserve Bulletin, table 1.11). Clearing balance data are also reported in the interest costs and profit required by competing pro forma balance sheet for Federal Reserve priced services in the Board of private suppliers, such as correspondent banks. Governors' Annual Report. Fair pricing requires a careful cost-accounting Whatever its choice, a bank will want to en- distinction between Federal Reserve non- sure that unexpected charges to its account do priced, central bank activities such as reserve not result in either penalties for daylight or over- requirements and the discount window, and its night overdrafts or reserve deficiencies, and priced service activities such as check clearing. that unexpected receipts do not lead to "wasted" Both activities may lead a bank to maintain a excess reserves. Moreover, the Federal Reserve deposit balance in an account at a Federal Re- Bank will need some assurance, as a prudent serve Bank. banker, that charges to a bank's account are Banks whose vault cash is not sufficient to made against a sufficient balance. Required satisfy their reserve requirement can meet the clearing balances address these needs. remainder of the requirement in either of two The mechanism for maintaining required ways. They can maintain funds in a deposit ac- clearing balances and receiving earnings credits count at a correspondent bank on a pass- was introduced in 1981 and modified in 1982 through basis, making it easier for them to use to include a penalty-free band.6 (See the ap- the services of correspondents without also pendix for a more detailed description.) This having to maintain an account at a Federal Re- arrangement is comparable to the compensating serve Bank to handle their payment needs. Al- balance method that some respondent banks ternatively, banks can maintain the required and commercial firms use to pay for commercial funds on deposit at a Federal Reserve Bank. bank services. A required clearing balance is an The Federal Reserve's priced service activi- average amount that a bank contracts to hold in a ties are those for which it is not the sole sup- deposit account during a reserve maintenance plier. These include collection of commercial period. This balance is over and above any re- checks, processing of commercial automated quired reserve balance it must hold in that period. clearinghouse items, wire transfer of funds and A bank's required reserve balance is determined government securities, safekeeping of definitive by deducting its holdings of vault cash from its securities, collection of noncash items, and total required reserve, which in turn is a percent- transportation of cash.4 age of the bank's deposits specified by regula- A bank that uses these priced services needs tion. A bank's required clearing balance is self- an account to which its payments and receipts determined, presumably so that it may avoid can be posted. Three possibilities exist. First, a overdrafts and receive earnings credits commen- bank can contract to have its activity posted to surate with its monthly bill from the Federal Re- a correspondent bank's Fed account. As just serve Bank. noted, this might be especially appealing to Periodically, a bank's actual maintained bal- those institutions already maintaining required ance is compared with its required balance. reserve deposits at a correspondent on a pass- Each business day, payments flow into and out through basis. Second, a bank that maintains a of a bank's Federal Reserve account. For each required reserve deposit at a Federal Reserve institution, the Reserve Bank records end-of- Bank might have its activity posted to that ac- day account balances and then averages these count. Historically, this has been the typical maintained balances for a reserve maintenance choice of banks using the Reserve Banks' pay- period of one or two weeks, depending on the ment services. Third, if required reserve depos- size of the bank. If the bank has no required its are unnecessary or inadequate for transaction clearing balance, its average maintained balance purposes, a bank might maintain additional bal- (after certain "carryover" adjustments discussed ances in its Fed account under the required below) should equal or exceed the required re- clearing balance arrangement.'5 Since 1981, banks have been able to pay for priced services with • 6 Each of the 12 District Banks provides official circulars and other earnings credits on required clearing balances. marketing materials informing customer banks about the terms on which priced services are available, including the required clearing balance op- tion. Operating to some extent as 12 distinct businesses, Banks have fol- lowed procedures for maintaining clearing balances that have differed • 4 The Reserve Banks also provide fiscal agent services for the U.S. somewhat in detail in the past. The most notable difference was in allocat- Treasury. A bank may use its Fed account to make and receive payments ing maintained balances between reserve and clearing requirements. associated with these services, whose costs are eovered by fees paid by Some Banks allocated balances first to the required and then to clearing either the banks or the Treasury. requirements, while others did the reverse. This practice affected the penalty structure on the initial amount of a deficiency, with some Banks as- • 5 Federal Reserve Banks have always been able to provide an ac- sessing required clearing balance penalties and others assessing count for customers who do not need to keep a required reserve balance required reserve penalties. However, banking consolidation across Fed- but who wish to make and receive payments there. Historically, this nor- eral Reserve District lines, as well as consolidation of some operations mal banking practice apparently involved only an incidental aggregate among the 12 Banks, has led to the uniform current set of procedures de- amount of overnight balances in clearing accounts. scribed here (see Conference of First Vice Presidents [1993]). serve balance (required reserves minus applied Frequent stops to fill up take time and may vault cash). If the bank also has a required clear- preclude unforeseen opportunities to buy gas ing balance, the average maintained balance, after at a lower price. However, buying gas at a low carryover, should equal or exceed the total re- price only when the tank is nearly empty risks quired balance plus or minus a penalty-free band.7 running out of gas. So, too, a bank that buys Maintained balances satisfy the reserve re- and sells funds frequently in order to keep its quirement first, and the remainder is used to balance close to the required amount at all satisfy the clearing balance requirement. A times may waste opportunities to buy or sell at bank is penalized if its balance falls short of the bargain rates, while buying or selling only required amount by more than a penalty-free when the funds rate is a bargain raises the risk band, at the rate of 2 percent on amounts up of overdrafts and failure to satisfy require- to 20 percent of the required clearing balance, ments, or of wasted balances. then 4 percent on amounts up to the whole re- Banks work toward a target balance over quired clearing balance, and at the discount seven or 14 calendar days (normally, five or 10 rate plus 2 percent on any remaining deficien- banking days), depending on the size of the insti- cies in required reserves. The bank receives earn- tution. Thus, a bank's cumulative required balance ings credits, based on the daily effective federal is seven or 14 times its average required balance. funds rate, on balances in excess of its required During the period, the account manager has a reserve up to the amount of its required clearing daily opportunity to target the day's closing bal- balance plus the penalty-free band (adjusted ance to add to the cumulative maintained balance. according to the bank's marginal reserve ratio; The cost of financing an extra dollar of bal- 8 see appendix). Beyond that point, a bank penal- ances is essentially the rate at which a bank izes itself for balances in excess of the required might borrow or lend in the federal funds mar- amount plus the penalty-free band, because the ket. This rate can vary noticeably over the excess funds receive no earnings credits. course of a single banking day, over differing The penalty-free band is the greater of 2 per- risk categories of borrower, and over days of a cent of a bank's required clearing balance or maintenance period. A bank does better, the $25,000. Thus, a bank with a minimum required more likely its manager is to "hit" the market clearing balance of $25,000 could satisfy the re- when the rate is attractive, in effect filling up quirement and receive earnings credits on the the fuel tank at places where gas is cheapest. amount by which its balance exceeds its required Clearly, the attractiveness of the rate depends reserve by anywhere from zero to $50,000, with- on the manager's judgment about how expen- out penalty. A bank with a $200 million required sive funds are relative to what they might be clearing balance would receive earnings credits over the remainder of the period (and, with on any balance above its required reserve up to carryover, over the following period). $204 million, and would satisfy its clearing bal- Ultimately, at the end of a maintenance pe- ance requirement without penalty when this bal- riod, the value of an extra dollar of balances is ance reached $196 million. determined by the structure of penalties and Required clearing balances affect the Fed's earnings credits within which the Reserve cost of providing priced services in two largely Banks administer requirements, including their offsetting ways. Total cost includes the earn- permissiveness in waiving penalties. For a ings credits that Reserve Banks grant on clear- bank operating with only a required reserve bal- ing balances ($177.8 million in 1992), reduced ance, ignoring carryover, a deficiency would be by an offset for unused credits. Total cost also penalized at a rate 2 percent above the discount is lowered by an offset for the income that Re- rate, and frequent deficiencies would bring con- serve Banks earn on assets financed with re- sultations aimed at changing management's be- quired clearing balances. This offset is imputed at the coupon-equivalent yield on three-month Treasury bills ($180.2 million in 1992).9 • 7 Hereafter, "required balance" will be used to indicate the sum of a required reserve balance and a required clearing balance.

II. Managing a • 8 Earnings credits are not added to the balance in the accounl, but Bank's Fed Balance accumulate for use in offsetting charges for priced services (on a first-in, first-out basis) within 52 weeks. In general, managing a bank's balance at its Fed- • 9 The amounts of these two items for calendar years are reported eral Reserve Bank is rather like managing one's as components of "Other income and expenses" in the pro forma balance fuel supply on an extended automobile trip. sheet for Federal Reserve priced services, published in the Board of Gov- ernors' Annual Report. havior. An excess would be wasted, costing A Maintenance something to finance but earning no interest. Period With this general background, the rationale for a bank's decision to hold a required clearing bal- A bank needs a strategy for maintaining a set ance can be investigated in three different time of overnight Fed balances whose average will dimensions — a day, one or two maintenance most profitably satisfy its balance requirements periods, and the long run of many maintenance for the period, taking into account both the periods. previous period's reserve surplus or deficiency and the possibility of carrying a reserve deficiency or surplus into the next period. A Day No single reserve management strategy ap- pears to dominate banking practice. Some Uncertainty can be a dominant factor in a sin- banks target the average daily balance neces- gle banking day. For a full-service bank, par- sary to meet the required balance (perhaps in- ticularly a very large one, the level of its final cluding a margin of safety), recalculated daily end-of-day balance results from its last-minute for the remaining days of the maintenance pe- interbank loan market maneuvering. A bank is riod. Others try to accumulate balances toward likely to be involved in daily payments and re- requirements only when the funds rate seems ceipts whose aggregate value is thousands of low relative to the expected rate for the pe- times larger than the required reserve balance. riod. Still others deliberately keep a lean posi- Thus, even slight deviations of payments or re- tion early in a period, lest a negative surprise ceipts from projected levels might flood or in required reserves or a positive surprise in re- drain the bank's Fed account during a day rela- ceipts provide more excess reserves than they tive to the typical desired end-of-day balance. could work off over the remainder of the pe- The manager of this account nonetheless must riod without overnight overdrafts. Also, some be able to come close to a targeted daily bal- banks try to alternate surplus and deficient pe- ance by arranging overnight borrowing or lend- riods, while others aim for a stable positive av- ing in the waning hours of the banking day in erage balance, using the carryover feature only amounts that can be far larger than the target to deal with big surprises. balance itself, and at attractive rates. Carryover. Without a required clearing bal- The protection that required clearing balance, a large bank's average balance for a ances provide against daylight and overnight maintenance period could be above or below overdrafts has become increasingly important the required level by as much as 8 percent of over the past decade. Reductions in reserve re- its required reserves (not just its required requirements and increased use of vault cash to serve balance). Large banks are permitted to satisfy requirements have left banks with carry over to the next period a surplus or defi- smaller required reserve balances, but with no ciency of up to 4 percent of required reserves, necessary change in the volume, time pattern, but they cannot carry any resulting surplus or or predictability of charges and receipts for deficiency into the following period. Eight per- transactions. All else equal, this would be ex- cent would result from using the maximum al- pected to increase the size and incidence of lowable carryover of a surplus/deficiency from overdrafts, both daylight and overnight. the previous period and carryout of the maxi- The Federal Reserve Banks have measured mum deficiency/surplus to the next period. and monitored daylight overdrafts with increas- Adding a required clearing balance widens ing precision over the last 10 years, with the range within which a bank can allow its amounts in excess of a minimum slated to be- maintained balance to fluctuate from one period come subject to a fee in April 1994. Overnight to the next while still satisfying requirements. overdrafts already are subject to penalty (the With the addition of a required clearing bal- greater of 2 percentage points above the dis- ance, the bank could be above or below the count rate or 10 percent). A bank without a re- (higher) required level by as much as 8 per- quired clearing balance might employ a variety cent of required reserves plus 8 percent of the of strategies to reduce the probability of over- required clearing balance. This is because the drafts, including targeting a higher level of non- clearing balance requirement itself provides a interest-bearing excess reserves. Contracting to penalty-free band of plus or minus 2 percent hold a required clearing balance would accom- of the required clearing balance, and maximum plish the same thing at almost no net cost, as allowable carryover is 4 percent of required re- long as the bank could use its earnings credits. serves, plus 4 percent of the required clearing balance, minus the penalty-free band of 2 per- • Allowable carryover, whether positive or cent of the required clearing balance. negative, may be greater, providing a larger A smaller bank (required reserves less than base either for interperiod rate arbitrage or for $1.25 million) without a clearing balance require- a bigger pool of funds from which to absorb ment could be above or below the required level unforeseen shocks to the closing balance on of balances by as much as $100,000, because the last day, as well as for the period. banks may carry over the larger of 4 percent of • The penalty-free band absorbs small de- required reserves or $50,000. However, adding a viations of actual from target balances without $25,000 minimum clearing balance requirement either penalty or wasted earnings. would not change the range within which that same small bank could allow its balance to vary. Allowable carryover would actually decrease to III. Three Issues $25,000 ($50,000 net of the minimum $25,000 Related to Required penalty-free band), offset by the ability to utilize Clearing Balances that penalty-free band. Measuring Bank Reserves and the The Long Run Monetary Base

Opting to maintain a required clearing balance Traditional measures of Federal Reserve mone- has obvious advantages for a bank. It can earn tary policy activity, including total and excess re- a market rate of return on relatively small bal- serves and the monetary base, are being affected ances that might not fetch such an attractive by the growing influence of required clearing bal- rate if sold as odd lots. Targeting a larger balances. The required clearing balance facility can ance means, on average, holding a larger bal- create an interest-bearing component of meas- ance, thereby creating a greater buffer against ured bank reserves quite distinct from the tradi- daylight and overnight overdrafts. Moreover, tional non-interest-bearing reserve assets. the bank gains flexibility in managing its bal- The potential influence of clearing balances ance, with the penalty-free band providing a can be seen by considering how the reserve convenient, costless margin of error around and monetary base aggregates are constructed the targeted balance that would be absent if it from six measured values, each of which is an were targeting a zero balance or only a re- average for a two-week reserve maintenance quired reserve balance. period. In addition to required clearing bal- With these benefits in mind, it might seem ances, the other five measured values include surprising that all banks do not obligate them- 1) Fed balances: The aggregation of over- selves for as large a clearing balance as their night balances of all depository institutions. need for earnings credits would support. Pre- 2) Applied vault cash: The amount of prior- sumably, this is because a bank's capital is a period vault cash holdings being used to sat- scarce resource, if for no other reason than isfy current-period reserve requirements. that banking regulations specify minimum lev- 3) Other vault cash: The difference between els of capital per dollar of total assets. Banks banks' current and applied vault cash.10 may restrict the volume of their required clear- 4) Currency in Ml: The portion of currency ing balances to the level at which, at the mar- in circulation held by the nonbank public. gin, it is more profitable to allocate scarce 5) Required reserves: The total amount of capital coverage to other assets that promise a reserves that banks are required to hold, as speci- better return than the expected spread be- fied in Federal Reserve Regulation D. tween the earnings credit rate on required Data are derived from banks' reports of depos- clearing balances and their cost of financing. its to the Federal Reserve and are assembled Adopting a required clearing balance thus with and without "adjustments to eliminate the has the following effects on a bank's manage- effects of discontinuities," or "breaks," associ- ment of its Fed balance: ated with changes in reserve requirements. • It holds a larger balance, with the addition The adjusted series estimates the amount of trans- likely to be financed at little or no net out-of- action deposit reserve requirements that would pocket cost, but requiring a modest allocation have prevailed in the past, had current reserve of capital. requirements been in effect; the unadjusted se- • Its incidence of daylight and overnight overdrafts would likely be lower. • 10 This is not the same as surplus vault cash (see Garfinkel and Thornton [1991]). FIGURE 2 The unadjusted monetary base emphasizes Reserve and Clearing Balance the federal government's role in providing Requirements: The Rules monetary assets directly to users in the private sector, rather than distinguishing between the quantities of private and public issues of Total reserves T money. The monetary base consists of all feder- I Plus maximum ally issued currency held by banks and the & H carryover range public (applied vault cash plus other vault XR cash plus currency in Ml), plus all deposit liabilities of Federal Reserve Banks to private A T * IK )2xPFB banks (Fed balances, including required clearing balances). The associated measure of 2% total reserves adds applied vault cash to Fed balances and then subtracts required clearing balances (because they are not reserves). Ex- cess reserves is the difference between this measure of total reserves and required reserves. Measuring total or excess reserves thus in- RCB RF volves distributing aggregate account balances between reserve balances and clearing balances. The current method does so by measuring reserve balances as all current balances other than required clearing balances.11 Any excess of maintained balances above the required clearing balance level, even within the penalty-free band (for example, point A in figure 2), thus augments RRB; aggregate total and excess reserves. Similarly, RD + 2 f AVC; any deficiency of maintained balances from the • required clearing balance level, both within and NOTE: XR = excess reserves; RCB = required clearing balance; RRB = required below the penalty-free band (for example, point reserve balance; AVC - applied vault cash; PFB = penalty-free band; RF = federal funds rate; and RD + 2 = discount rate. B in figure 2), reduces aggregate total and excess SOURCE: Author. reserves, even though the bank may have satis- fied its reserve requirement. ries reports the then-current actual requirements. A potential implication of this measurement Required clearing balances are excluded from convention can be illustrated by imagining an all measures of reserves, by definition, and from extreme case. Suppose that all banks were to the adjusted monetary base, but are included in move simultaneously from the upper to the the unadjusted monetary base. This treatment is lower edge of their respective penalty-free consistent with the differing purposes of the two bands between adjacent maintenance periods. measures of the monetary base. Within a 2 percent penalty-free band above The adjusted series emphasizes the role of and below the current $6 billion of required base money as actual or potential reserve as- clearing balances, actual total and excess re- sets. These are the high-powered "tickets" that serves would vary by about a quarter of a bil- banks must hold when issuing reservable de- lion dollars, with banks largely indifferent to posits, with the amount issued per ticket con- the change. That is, their earnings loss from strained by a reserve requirement. The adjusted holding a lower balance at the Fed would be monetary base includes the reserve assets held approximately equal to their earnings gain from both by banks (adjusted total reserves plus vault financing a lower balance. With many banks, cash not being used to meet reserve requirements) some holding more and some holding less and by the nonbank public (currency in Ml). A than their required clearing balances, positive historically consistent measure of adjusted total and negative deviations from required clearing reserves has been derived by adding the actual balances within penalty-free bands would likely historical quantity of excess reserves to adjusted required reserves. Similarly, because banks' balances held to meet a clearing balance require- • 11 Adjusted total reserves equals adjusted required reserves plus ment cannot be used to satisfy reserve require- actual excess reserves, which in turn equals applied vault cash plus Fed balances net ot required reserves and required clearing balances. Unad- ments, the adjusted monetary base excludes justed total reserves equals applied vault cash plus Fed balances net of required clearing balances. required clearing balances. tend to be offsetting. More generally, however, system becomes less effective in smoothing the greater the participation in required clearing interest rates.13 balance arrangements, the more probable that With these impediments in mind, the rapid modest variations either in the supply of bank growth of required clearing balances in recent balances at the Fed, in total and excess re- years might be linked to the cuts in reserve reserves, or in the adjusted monetary base would quirements of December 1990 and April 1992.14 be a matter of little moment to banks, since Banks increased their required clearing bal- their net earnings would be unaffected.12 ances by more than a third in the month follow- The essential issue here is whether total and ing the December 1990 cut and doubled their excess reserves, as now measured, match any requirements within a year (see figure 1). How- useful economic concept. The measures have no ever, it would not be easy to distinguish the im- necessary counterpart at the level of an individ- pact of lower reserve requirements from that of ual bank managing its reserve position, because either rising bills for priced services or declining carryover and penalty-free bands are unrecog- interest rates. nized. Banks that perpetually maintain current The utility of earnings credits lies in paying balances in excess of current requirements truly bills for priced services, so the size of these have current-period "excess" reserves. Other bills places an upper limit on the volume of banks, however, will be in different stages of us- clearing balances that banks could find useful. ing carryover, either satisfying some of their cur- In the aggregate, the percentage of total sales rent reserve requirements with surplus balances of priced services paid with earnings credits, from adjacent periods, or using current surplus while growing, was still less than 20 percent balances to satisfy some of their reserve require- in 1992. There is some indication that banks, ments in adjacent periods. including some with the largest required clear- Carryover itself does not destroy the utility ing balances, do tend to adjust their require- of the current measures: A positive shock to ments in concert with the magnitude of their the supply of reserves in one period, for exam- bills. What would be difficult to discover, how- ple, tends to imply a comparable negative ever, is the extent to which annual growth of shock to demand for total and excess reserves billings has "caused" the growth of required in the next period, and the System can rely on clearing balances. More important for the fu- that carryover relationship in managing next- ture would be to determine what portion of period supply. The difficulty comes from the the remaining 80 percent of the priced services addition of a penalty-free band, which makes revenue billed to banks would be capitalized it impossible to know whether a shock to re- as additional required clearing balances if re- 15 serve supply will affect next-period demand serve requirements were cut further. through carryover, or simply be accommo- Many banks could be expected to adjust dated as earning assets this period through the balances to keep pace with bills because their penalty-free band. required clearing balances are likely to be financed at a slightly positive rate spread, making priced services cheaper when paid from Sources of Growth earnings credits. Earnings credits are calculated in Required Clearing on the basis of the daily effective federal funds Balances rate, which is the quantity-weighted average rate paid by all borrowers of unsecured over- Managing a bank's required reserve balance at night balances each day. Large banks operat- successively lower levels of reserve require- ing actively in the interbank funds markets ments has been likened to landing an airplane on a shrinking aircraft carrier. As the target balance gets closer to zero, there is less room for error. Averaging within a maintenance period • 13 Feinman (1993) provides an excellent analysis of these relation- provides less opportunity to absorb surprises, ships. as does the possibility of carrying forward ex- • 14 The 1990 action reduced the 3 percent reserve requirement cesses and deficiencies. Overall, the banking against nontransaction deposits to zero, lowering required reserves by an estimated $13.7 billion. The 1992 action reduced from 12 percent to 10 percent the highest marginal reserve requirement on net transaction de- • 12 Paying interest on total or excess reserves would not preclude posits, cutting required reserves by an estimated $8.9 billion. effective monetary policy. See Dotsey's (1991) investigation of monetary policy operating procedures in New Zealand, where there are no reserve • 15 Hilton, Cohen, and Koonmen (1993) have investigated this requirements and where banks settle using a below-market interest-bearing question, as well as a variety of techniques that might expand the use of asset whose supply is controlled by the central bank. required clearing balances. thus might expect to acquire marginal financ- cuts in reserve requirements might bring signifi- ing at rates averaging less than the effective cant institutional changes in banking and pay- rate, because foreign buyers and some others ment arrangements, with increased privatization typically pay risk premiums that large domestic of payment services to avoid daylight over- banks, for example, do not pay. This would in- drafts, or with new Federal Reserve arrange- sert a profit wedge between the effective rate ments to ensure that deposit balances at the used in calculating earnings credits and the Fed remain an effective vehicle for monetary cost of financing required clearing balances. policy implementation (Meulendyke, ed. [1993], With this in mind, some of the past growth in Stevens [1991a, 1992]). required clearing balances probably reflects Additional cuts in required reserves could re- the increase in total sales of priced services duce the System's effectiveness in interperiod and the attraction of paying with earnings cred- smoothing of short-term interest rates. Reserve its. In fact, if this relationship were one for carryover plays a role in this smoothing proc- one, about 14 percent of the growth of re- ess, allowing the banking system to absorb un- quired clearing balances since 1990 might re- intended variations in the System's supply of flect growth of total sales of priced services. balances. The penalty-free band can serve the Putting aside billing magnitudes, the level of same purpose, but has different implications the federal funds rate can also exert an inde- for policy implementation. Banks tend to "make pendent, powerful influence on the size of a up" reserve deficiencies and surpluses in the required clearing balance needed to produce a next period, providing the System with a vital dollar's worth of earnings credits. For example, clue to interperiod variations in demand for the to hold earnings credits constant at their 1990 balances it supplies. This is lacking in the op- value, the substantially lower federal funds rate eration of the penalty-free band. Thus, the Sys- would have called for a 6l percent increase in tem could face multiperiod runs of demand for required clearing balances by 1992. balances below or above a required level. Even if, for purposes of argument, demand An additional policy implementation prob- for required clearing balances had been direct- lem may arise from the earnings credit feature of ly proportional to billings and inversely propor- required clearing balances. Restrictive policies tional to the level of the federal funds rate, banks will cany within themselves the seeds of their added about $1 billion more to their holdings of own disorganization. That is, as the federal funds required clearing balances after 1990 than the hy- rate rises, the quantity of clearing balances pothetical amounts these two forces would have needed to pay for a given quantity of Reserve produced. This suggests that banks have been Bank priced services will decline, increasing the induced to replace required reserve balances possibility of the interest-rate variability associ- with required clearing balances. The relative in- ated with low balances. A high interest-rate pol- fluences of the three forces are not clear, how- icy might also discourage use of some Federal ever, because their movements have been corre- Reserve payment services, by reducing the nomi- lated. Clarifying their relative importance will be nal quantity of Fed balances available for imme- crucial in dealing with some of the policy issues diate transfer within overdraft limits. with which required clearing balances may be- Relying on required clearing balances as the come associated. vehicle for implementing monetary policy thus raises a more general question. Is a bank's required clearing balance a by-product of its Monetary Policy choice of the Fed as the best among alternative Issues suppliers of services, or is the choice of the Fed's priced services a by-product of the bank's need Reserve requirements are a tax whose cost has for a larger balance? In either case, the Monetary become a serious issue in the United States in Control Act's neat distinction between central recent decades, as the competitive niche of tra- bank activities and priced service activities is not ditional banking has faded in financial markets. as clear-cut as it once appeared. Lower requirements can increase Federal Re- serve payment system risk exposures through daylight and overnight overdrafts, can contribute to volatile overnight interest rates that could hamper monetary policy implementation, and can degrade the value of central bank payment • 16 Feinman (1993) finds that for a sample of large banks from services (Stevens [1989, 1991b, 1993]). Further 1987 to 1991, excess reserves and carry in had opposite signs about 90 percent of the time. IV. Conclusion bearing required reserve balances at the Federal Reserve Banks to historically low levels relative The emergence of required clearing balances is to bank deposits and the monetary base. All changing the institutional setting in which indi- else equal, continuing along this trend would vidual banks manage their Fed balances. Banks require some combination of changes in mone- are able to hold balances substantially larger tary policy implementation and in the payment than dictated by reserve requirements, provid- system to accommodate the absence of cash in- ing greater flexibility in avoiding overdrafts ventories in the banking system. Alternatively, and meeting reserve requirements—and at required clearing balances could provide a new minimal cost. basis for banks to hold deposits at the Federal Familiar aggregate data series are being af- Reserve Banks, but whether this is feasible re- fected by bank holdings of required clearing mains to be demonstrated. balances. In effect, a definable, probably small, but as yet unmeasured portion of the total and excess reserves of the banking system is now Appendix earning assets, rather than being held as non- interest-bearing vault cash or reserve deposits. Required Balances: More important, marginal variations in banks' The Rules17 Fed balances increasingly take place within the earnings and cost structure of required clearing Current reserve and clearing balance require- balances, not required reserve balances. ments include two types of rules: those for Growth of required clearing balances relative computing and maintaining required balances to required reserve balances raises questions and those for calculating earnings credits and that need further investigation. Can required penalties. clearing balances be expected to replace re- Many banks are "unbound" — that is, either quired reserve balances if reserve requirements they have a zero reserve requirement or they are cut further? How would monetary policy meet the requirement entirely with vault cash. implementation be influenced when a change These banks nonetheless may maintain a re- in the money market stance of policy affects quired clearing balance. Other banks are not only the marginal cost but also the mar- "bound" by a positive reserve requirement that ginal revenue of many banks' Fed balances? exceeds their vault cash. They must maintain a To what extent does the demand for clearing required reserve balance, but do not hold a re- balances reflect a desire to pay bills with earn- quired clearing balance. A large number of ings credits, and to what extent does it reflect banks, however, are both bound to hold a re- a demand for larger balances? If demand is quired reserve balance and elect (or have been mainly for convenient bill paying, could Fed- asked) to hold a required clearing balance. eral Reserve priced services generate a pool of The rules laid out here, and summarized in balances large enough to maintain a smoothly figure 2, are for a bank that must meet a com- operating money market when interest rates bined reserve and clearing balance, maintained are high? On the other hand, if demand is on the biweekly basis that is typical of a rela- mainly for a level of balances high enough to tively large institution. The other two cases accommodate transaction needs, could banks may be derived by dropping all references to a use all of the Federal Reserve priced services required reserve balance or to a required clear- their balances could buy when interest rates ing balance, as the case may be. Note that in are high? maintaining a balance, a bank that holds only Congress created the Federal Reserve Sys- a required clearing balance cannot use the car- tem as a single response to the joint desire for ryover feature, and a bank that holds only a re- a more uniform national payment system and quired reserve balance cannot use the for a regulator of the nation's money supply. penalty-free-band feature. The mandate of the Monetary Control Act of 1980 was that these two functions should exist independently, in the sense that the Federal Reserve Banks could no longer provide free payment services to offset banks' costs of maintaining required reserves. Subsequent cuts in re- • 17 From Standard Operating Procedure 10.0, Conference of First serve requirements have allowed the banking Vice Presidents (1993). See also Board of Governors of the Federal Re- system to reduce its holdings of non-interest- serve System, Monetary Policy and Reserve Requirements Handbook, Washington, D.C.: Federal Regulatory Service. Computing and allocated toward the required clearing balance. Maintaining a The band is 2 percent of the required clearing Required Balance balance, or $25,000 if the required clearing balance is less than $1.25 million. A bank's required balance, RB, is not a unique A bank's maintained balance, MB, is the av- dollar amount, but a range around the com- erage daily closing balance in its Fed account, bined required balance. averaged over a two-week maintenance period (for a typical large bank) that begins on a RB = (RRB + RCB) ± PFB. Thursday and ends on a Wednesday, two days after the end of the required reserve computa- The combined required balance includes a tion period. required reserve balance, RRB, that is the Carryover provisions allow a bank to carry bank's total reserve requirement, RR, net of its forward to the next maintenance period an ex- applied vault cash, AVC. cess or deficiency in its maintained balance to the extent that it is offset by a deficiency or ex- RRB= RR-AVC. cess in the next period. The amount of carryover can be no more than (0.04 [RR + RCB] - The total reserve requirement is computed PFB) and cannot be carried forward more than by applying appropriate marginal reserve re- one period. Note that the limit on eligible carry- quirement ratios to the amount of a bank's over is based on a bank's reserve requirement, transaction deposit liabilities in each of three RR, not on its reserve balance requirement. "tranches." In 1993, requirements are zero on the first $3.8 million of deposits, 3 percent on additional deposits up to $46.8 million, and 10 Earnings Credits, percent on deposits in excess of $46.8 million. Penalties, and Requirements typical of large banks are Wasted Balances computed on the basis of daily average transaction deposit liabilities outstanding during suc- Earnings credits provide a return on required cessive two-week reserve computation periods clearing balances that can be used only to pay ending every other Monday. Applied vault for Federal Reserve Bank priced payment serv- cash is the bank's daily average holdings dur- ices.18 Required reserve and surplus balances ing the 14-day period that ends three days be- earn nothing. The return is based on the average fore the beginning of the maintenance period. federal funds rate during the maintenance period The required clearing balance, RCB, is nor- in which the required clearing balance was held. mally a dollar amount agreed to by the bank The funds rate is applied on an annualized basis and its Federal Reserve Bank, with a $25,000 to the actual average daily clearing balance (with- minimum. As stated by the Federal Reserve in the upper limit of the penalty-free band), ad- Bank of Cleveland (1992), justed by the bank's marginal reserve requirement ratio. A bank subject to the 10 percent marginal The prescribed level of an institution's clearing bal- reserve requirement will earn the funds rate on ance will be determined in consultation with the in- its entire allowable clearing balance, a bank stitution on the basis of the deposit size of the subject to a 3 percent marginal requirement institution, the volume and type of services that are will earn the funds rate on only 93 percent of or will be used, and the need to avoid account that balance, and a bank subject to a zero mar- overdrafts.... This Bank may make adjustments in ginal reserve requirement will earn the funds the prescribed level of an institution's clearing bal- rate on only 90 percent of the balance. ance from time to time as may be appropriate. The marginal reserve requirement adjustment Such adjustments will normally be made no more incorporates two factors that allow Federal Re- than once a month and will be effective on the first serve Banks and correspondent banks to pro- Thursday of the month that coincides with the first vide similar services to customer banks on the day of a maintenance period. "level playing field" envisioned in the Mone-

The penalty-free band, PFB, for required clearing balances establishes a range of balances that will satisfy the combined required balance, be- • 18 More specifically, earnings credits cannot be used to pay pen- cause actual holdings are allocated first toward alties for clearing balance deficiencies or to cover charges related to non- priced service functions of the Federal Reserve Banks, such as penalties the required reserve balance, with the remainder for deficient required reserve balances, interest on discount window loans, and cost recoveries for providing accounting information services. tary Control Act. To illustrate, first suppose that References correspondent banks have a 10 percent marginal reserve ratio and that the incidence of the cost of a correspondent's reserve require- Coats, Warren L., Jr. "What Do Reserve Carry- ment is on its respondent customer banks. overs Mean for Bank Management and for This suggests that the Reserve Banks might Free Reserves?" Journal of Bank Research, give earnings credits on only 90 percent of a Summer 1976, pp. 123-27. required clearing balance to avoid placing themselves at an advantage relative to corre- Conference of First Vice Presidents. Subcommit- spondent banks in providing priced services. tee on Accounting Systems, Budgets, and Ex- Second, recognize that a bank paying for penditures, Standard Operating Procedure correspondent bank services with earnings 10.0. Washington, D.C.: Board of Governors credits on balances held with the correspon- of the Federal Reserve System, 1993- dent is able to deduct the amount of those balances from its own deposit liabilities subject to Dotsey, Michael. "Monetary Policy and Operat- reserve requirements. (Deducting amounts "due ing Procedures in New Zealand," Federal Re- from other banks" avoids double-reserving of serve Bank of Richmond, Economic Review, interbank deposits.) If the same bank were to vol. 77, no. 5 (September/October 199D, buy services of equal value from a Federal Re- pp. 13-19. serve Bank and pay for them with earnings credits on a required clearing balance, it would Evanoff, Douglas D. "Reserve Account Manage- lose the deduction. This is irrelevant for a bank ment Behavior: Impact of the Reserve Ac- with a zero marginal reserve requirement, but counting Scheme and Carry Forward not for those reserving 3 percent or 10 percent Provision," Federal Reserve Bank of Chi- at the margin. Therefore, the Fed should give cago, Working Paper No. 89-12, June 1989. earnings credits on 93 percent or 100 percent of required clearing balances, depending on Federal Reserve Bank of Cleveland. "Mainte- the customer's marginal reserve ratio, to avoid nance of Reserve and Clearing Accounts," placing itself at a disadvantage relative to corre- Operating Letter No. 4, August 27, 1992. spondents in providing priced services. Penalties are imposed on a bank whose Feinman, Joshua. "Bank Reserve Management, maintained balance is deficient, to the extent Overnight Overdraft Penalties, and Carryover: that the deficiency is not offset by carryover Theory and Evidence," Board of Governors from the previous period or to the next period. of the Federal Reserve System, unpublished Maintained balances are allocated first toward manuscript, June 1993- the required reserve balance, with the remainder allocated toward the required clearing bal- Friedman, Richard M., and William W. Roberts. ance. A bank pays a penalty at an annual rate "The Carry-Forward Provision and Manage- that rises with the size of the deficiency: no ment of Bank Reserves," Journal of Finance, penalty on the first 2 percent (or $25,000) of vol. 38, no. 3 (June 1983), pp. 845-55. the required clearing balance (the penalty-free band), 2 percent of the next 18 percent of the Garfinkel, Michelle R., and Daniel L. Thornton. required clearing balance (or of the next 20 "Alternative Measures of the Monetary Base: percent minus $25,000), and 4 percent of the What Are the Differences and Are They Im- remainder of the required clearing balance. portant?" Federal Reserve Bank of St. Louis, Deficiencies that extend into the required re- Review, vol. 73, no. 6 (November/December serve balance are penalized at a rate 2 percent- 199D, pp. 19-35. age points above the discount rate. Balances can be said to be wasted to the ex- Hilton, Spence, Ari Cohen, and Ellen Koonmen. tent that they exceed the required range and "Expanding Clearing Balances," in Ann-Marie are not carried forward to the next period. Such Meulendyke, ed., Reduced Reserve Require- balances do not contribute to satisfying a re- ments: Alternatives for the Conduct of Mone- serve or clearing balance requirement and do tary Policy and Reserve Management, New not receive earnings credits. York: Federal Reserve Bank of New York, April 1993, pp. 109-35. Poole, William. "Commercial Bank Reserve Man- agement in a Stochastic Model: Implications for Monetary Policy," Journal of Finance, vol. 27 (December 1968), pp. 769-91.

Spindt, Paul, and Vefa Tarhan. "The Liquidity Structure Adjustment Decision of Large Money Center Banks," Board of Governors of the Federal Reserve System, Special Stud- ies Paper No. 121, October 24, 1978.

Stevens, E. J. "Removing the Hazard of Fedwire Daylight Overdrafts," Federal Reserve Bank of Cleveland, Economic Review, vol. 25, no. 2 (1989 Quarter 2), pp. 2-10.

. "Federal Funds Rate Volatility," Federal Reserve Bank of Cleveland, Eco- nomic Commentary, August 15, 1991a.

. "Is There Any Rationale for Re- serve Requirements?" Federal Reserve Bank of Cleveland, Economic Review, vol. 27, no. 3 (1991b Quarter 3), pp. 2-17.

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