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Reserve Requirements, Deposit Insurance and Monetary Control

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Reserve Requirements, Deposit Insurance and Monetary Control 79-7 RESERVE REQUIREMENTS, DEPOSIT INSURANCE AND MONETARY CONTROL Robert D. Laurent m O m 70 > r~ 70 m Ln m 70 < m CD > Z 7^ 0 -n n x n > o o Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Reserve Requirements, Deposit Insurance and Monetary Control by Robert D. Laurent Department of Research Federal Reserve Bank of Chicago The views expressed herein are solely those of the author and do not necessarily represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. The material contained is of a prelimi­ nary nature, is circulated to stimulate discussion, and is not to be quoted without permission. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Reserve Requirements, Deposit Insurance and Monetary Control Reserve requirements are usually justified on grounds that they enhance the monetary authorities1 control over monetary aggregates. Using reserve requirements to control a monetary aggregate has long posed a problem for economists in devising an institutional structure in which to operate monetary policy. Higher reserve requirements give more accurate control over the target monetary aggregate, but they impose higher taxes on banks and bank customers. Building on a reserve computation system presented earlier, this paper proposes a change in institutional structure that essen­ tially merges the monetary policy functions of the Federal Reserve with the deposit insuring authority of the Federal Deposit Insurance Corporation. The proposed system would provide accurate weekly con­ trol over the target monetary aggregate while completely eliminating the reserve requirement tax. The proposal would also simplify banks1 portfolio and reserve management tasks and help insulate the target monetary aggregate from replacement in the publicfs demand function by other financial assets. Aside from the benefits of an improved monetary policy, banks, bank customers, and taxpayers would receive direct pecuniary benefits. Finally, the proposal would simplify (and provide a compelling economic rationale for) the role of govern­ ment in the financial system. These benefits would be obtained with­ out any additional compulsory measures. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The paper is divided into four sections. The first reviews the problem of reserve requirements and monetary control and previous proposals to deal with it. The second describes the proposed system. The third provides the economic rationale for the role of government in the proposed system. The final section describes bank techniques of reserve management under the proposed system. The Problem It has long been recognized that reserve requirements affect the ability of the central bank to control any given target monetary aggregate. Generally, the higher the reserve requirements, the more accurate is control over the target aggregate. A simple way to per­ ceive the effects of different reserve requirements ratios begins by noting that the higher reserve requirements, the lower the multi­ plier between reserves and deposits. By reducing the multiplier between reserves and deposits, higher reserve requirements reduce the size of the disturbances to deposits caused by aberrations in reserves. More importantly, the higher are reserve requirements, the lower and presumably less volatile are excess reserves. Banks hold less excess reserves because higher levels of reserve requirements reduce the deficiency resulting from a deposit outflow. The less volatile are excess reserves, the more predictable is the relationship between reserves and money and the better the control over money. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 3 - Higher reserve requirements act as a tax on banks and bank customers. Banks essentially economize on currency. They offer depositors a convenient, safe, and economical way to perform trans­ actions without physically transferring currency. In addition, be­ cause banks need reserve levels that are only a fraction of deposits, they are able to pay interest on deposits. These interest payments on deposits are a benefit of the technological innovation banking represents. In a world of commodity currency, these interest payments reflect the physical resources saved in economizing on the commodity currency (e.g., the real resources consumed in mining gold). In a world of fiat currency, these real resources are already saved in the production of currency. With fiat currency, deposit interest, which represents one benefit of banking, is a transfer from government to deposit holders. To control a monetary aggregate effectively, reserve requirements should be higher than banks would voluntarily hold. This is necessary so as to have banks’ excess reserves close to zero and, therefore, predictable.^ The higher reserve requirements are raised above the voluntary level, the closer excess reserves move to zero and the more predictable the relationship between reserves and deposits. But, the higher are reserve requirements, the greater the tax on deposits and the smaller the interest payments to depositors. There is nothing unique about the relationship between government and the banking industry that justifies a government tax on banking. Banks can exist alongside commodity currency and without government chartering as well Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 4 as with government fiat currency and government chartering. The justification for the reserve requirement tax rests simply on the need to accurately control a target monetary aggregate. One's preferences on the trade off between monetary control and the reserve requirement tax is likely to be determined by the importance one attaches to monetary control. Some economists who place great importance on monetary control have advocated 100 percent reserve require­ ments in the form of vault cash and reserves at the Federal Reserve against demand deposits. This proposal was first circulated in the 1930s by a group of University of Chicago economists, the most prominent of whom was Henry C. Simons.^ The proposal was subsequently advanced in slightly different forms by other economists.^ One hundred percent reserve requirements would give the monetary authorities very accurate control over demand deposits and the target monetary aggregate. How­ ever, without the ability to economize on reserves, banks could not afford to pay interest on demand deposits. Banks could still accept demand deposits and provide depositors with the convenience and safety of check transfers, but they would require payment for these services. In contrast, one could easily hold a diametrically opposing view (eliminate reserve requirements) if one believes either that monetary policy is not important or that, if important, it is implemented through measures other than monetary aggregates (e.g., interest rates). For an economist with such views, there would be little gained from the tax imposed by reserve requirements if monetary policy is not effective. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 5 - Similarly, for a monetary policy implemented through interest rates, reserve requirements would seem superfluous.^ An important refinement was added to the 100 percent reserve requirement proposal in the 1940s. In an effort to eliminate the tax effect of 100 percent reserves, it was suggested that government pay interest on reserves. Perhaps the most familiar of these proposals was made by Milton Friedman,-* who also proposed the elimination of controls on interest payments on deposits combined with free entry into banking. Like the basic 100 percent reserve requirement proposal, this system would give accurate control over the target monetary ag­ gregate. The interest payment on reserves would serve to offset the reserve requirement tax.^ Allowing market rates of interest on de­ posits along with free entry into banking would insure that interest payments on reserves were passed along to depositors. Paying interest on reserves remains one of the most viable proposals for resolving the problem of monetary control and the reserve requirement tax. One major problem with the proposal is the practical difficulty of deter­ mining the interest payment needed to offset the cost of holding reserves. Ideally, the interest payment to each bank would just com­ pensate for the additional cost of meeting reserve requirements. Any higher payment would be a subsidy, any lower payment would not eliminate the tax. In addition, the specifics of how interest would be paid on reserves and how this would ensure accurate control over the monetary target have not been precisely spelled out.^ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 6 - The Proposal This paper proposes a different solution to the problem of monetary control and reserve requirement taxes. This solution uses a reserve computation system presented by the author in an earlier article.® This system, referred to as the reverse lag, reverses the present system in which the required reserves a bank must meet is based on deposits two weeks before. Under the reverse lag, a bank matches required reserves in the current week to its reserves in the previous week. The reverse lag system allows the monetary authorities to accurately set weekly required reserves. Most importantly, it works no matter
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