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Reserve Requirements: A Modern Perspective
SCOTT E. HEIN AND JONATHAN D. STEWART Hein holds the Briscoe Chair in Bank Management and Finance at Texas Tech University and is a visiting scholar at the Atlanta Fed, and Stewart is a professor at Abilene Christian University. They thank the Rawls College of Business Administration at Texas Tech University for providing financial support to access newswire stories relating to the 1992 reserve require- ment change. In addition, they thank participants at a Texas Tech University finance area workshop, Jerry Dwyer, Steven T. Jones, Thomas H. Payne, Mark Swanstrom, Paula Tkac, Larry Wall, and William Whitesell for comments on an earlier draft of this paper.
he Federal Reserve requires depository ment ratios) far more reserves than desired by the institutions to hold a minimum level of Fed in a short time period. For another thing, if the non-interest-earning reserves (vault cash Fed is targeting the federal funds rate, and if the Fed or deposits at the Fed) in proportion to does not change its target for the funds rate at the their depository liabilities. A cursory time of the reserve requirement change, then it reading of typical money and banking must offset the reserve requirement change impact textbooksT would suggest that these requirements if it wants to maintain the federal funds rate at its are there for a couple of reasons. For one, reserve original target level. Consistent with this idea, the requirements are a tool of monetary policy. Reduc- Fed routinely offsets the monetary policy effects of tions in reserve requirements would allow the Fed changes in reserve requirements. In other words, to expand the money supply and lower interest rates. what the Federal Reserve gives with one hand by A second reason for the reserve requirements is to lowering reserve requirements, for example, it takes improve the safety and soundness of depository insti- back with the other hand using contractionary open tutions. The higher the reserve requirement, the market operations. safer depository institutions are held to be. This evidence raises an interesting question: If Interestingly, this “conventional wisdom,” while the Federal Reserve offsets the policy effects of still commonplace in academia, does not appear to reserve requirement changes, then why does it be shared by the Federal Reserve—or other central change the reserve requirement ratios to begin with? banks, for that matter. This article challenges con- It is suggested that the Fed is frequently trying to ventional wisdom from textbooks on both of the achieve other, non-monetary-policy objectives when above points. First, it challenges the notion that it changes reserve requirements. In particular, in reserve requirement ratio changes are simply one of 1992 the Federal Reserve used reserve requirement three tools, along with the discount rate and open changes to bolster the financial health of depository market operations, at the disposal of the Federal institutions. This article provides testimony from the Reserve System for implementing monetary policy. public record that when the Fed last officially changed The article argues that this view is too narrow. For reserve requirements, in 1992, it was attempting to one thing, it ignores the economic and financial sig- ease the credit crunch of that time and improve the nificance of reserve requirements changes. Changes profitability of depository institutions without in reserve requirement ratios typically free up or expanding the money supply or lowering interest absorb (depending on the change in reserve require- rates. In this vein, there is a large body of empirical
Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 41 evidence indicating that changes in reserve require- ment ratios to accomplish monetary policy objec- ment ratios result in significant changes in the value tives.1 There are a number of reasons to believe that of equity for depository institutions. reserve requirement changes rarely have been indica- Second, the article challenges the notion that tive of monetary policy initiatives. First is the recog- higher reserve requirements necessarily lead to nition that even small changes in reserve requirement greater safety and lower default risk for depository ratios can have large monetary policy effects. On institutions. Again, we investigate how the 1992 February 18, 1992, the Federal Reserve announced a reserve requirement change affected interest rates lowering of the reserve requirement ratio on transac- and, more importantly, interest rate spreads that tion deposits to 10 percent from 12 percent for proxy for default risk premiums. We examine large depository institutions. Based on the reserve whether the reserve requirement reductions actually adjustment magnitude of the Federal Reserve Bank worsened the perceived safety of depository insti- of St. Louis, it is estimated that this action freed up tutions, as conventional wisdom would suggest. We the equivalent of about $7.3 billion in reserves find no new evidence that the 1992 reserve require- (Anderson and Rasche 1996). The Fed would have had to buy over $7 billion in government securities to have the same expansionary effects. Such a pur- chase would have been more than the Fed bought in all of 1991, for example. In other words, in a matter There are a number of reasons to believe that of a few moments, when the Fed changed reserve reserve requirement changes rarely have been requirement ratios in February 1992, it provided the equivalent injection of reserves that it provided indicative of monetary policy initiatives. in the full preceding year. Because these large, dis- crete policy effects are generally undesirable, the Fed is forced to neutralize them. Moreover, for most of the post–World War II period, the Federal Reserve has been stabilizing short-term ment ratio reduction increased the perceived interest rates in its day-to-day operations. In fact, only default risk of depository institutions at the time it two weeks before the 1992 reserve requirement was announced. In fact, proxies for default risk pre- reduction announcement, the Federal Open Market miums for depository institutions actually narrowed Committee (FOMC) met on February 4 and 5, 1992, to at the time. This evidence contradicts the conven- discuss changing its interest rate target. Ritter (1993) tional wisdom that suggests lower reserve require- summarizes this meeting as follows: “In setting policy ments would lead to higher default risk. for the weeks until the next meeting, there was a clear This article first examines the relationship consensus that no dramatic action should be taken, between reserve requirement changes and monetary particularly since significant easing had been taken in policy, with the aim of showing that reserve require- late 1991” (43). In other words, the FOMC had just ments are not a very useful monetary policy tool and voted not to change the target for the federal funds have not been used for this purpose recently. The rate. This action meant that the expansionary effects discussion next considers the more modern view of of a reserve requirement reduction required an reserve requirements as a tax on depository institu- absorbing of reserves through open market opera- tions and summarizes a large and growing literature tions. If the expansionary effects were not offset, then on the incidence of this tax. This evidence suggests short-term interest rates would have fallen as a result that perceived bank profitability is inversely affected of the increase in reserve availability. Thus, it is logical by announced changes in reserve requirement ratios. to anticipate, based on the Fed’s recent stabilization of The article then develops the default risk issues asso- short-term interest rates, that reserve requirement ciated with reserve requirement changes, providing ratio changes will be accompanied by offsetting open new evidence that reserve requirement reductions market operations. For example, a reduction in are associated with a decline in default risk for finan- reserve requirement ratios will lead to simultaneous cial institutions that issue reservable instruments. open market sales while an increase in reserve requirement ratios will lead to simultaneous open Reserve Requirement Ratio Changes and market purchases. Thus, if the Federal Reserve were Monetary Policy to announce a new reduction in reserve requirement e begin with the assertion that the Federal ratios without also announcing a change in its federal WReserve has not often changed reserve require- funds target, the Federal Reserve could be expected
42 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 to simultaneously sell government securities to offset further easing of monetary policy in the near future. the increase in excess reserve availability. He confirmed that the reduction in reserve require- There is strong empirical evidence that such off- ments for commercial banks announced on Tuesday setting has taken place for many years. Haslag and was intended to boost bank profitability and ease Hein (1989) provide evidence for the 1960–88 period, the credit crunch rather than an easing of monetary for example, that the Federal Reserve typically off- policy” (“Greenspan sees early…” 1992). Since the sets reserve requirement ratio changes with open Federal Reserve had not announced a decrease in its market operations through its holdings of government federal funds rate target along with the announced securities (the primary ingredient of the source base). reduction in reserve requirements, the change in They find that “when the Federal Reserve lowers reserve requirement ratios should be properly reserve requirement ratios, a simultaneous contrac- viewed as no change in monetary policy. tion in the growth rate of the source base is typically undertaken” (11). Reserve Requirements as a Tax on Further support of this position is offered by the Depository Institutions most recent official change in reserve requirements he summary of Greenspan’s testimony suggests in the United States. On February 18, 1992, when Tthat the Federal Reserve lowered reserve the Federal Reserve announced a lowering of the requirements on transaction deposits in 1992 to reserve requirement ratio on transaction deposits, improve the profitability of depository institutions Alan Meltzer, economics professor at Carnegie and thus encourage them to lend more. But how Mellon University and chairman of the Shadow would lowering reserve requirements improve bank Open Market Committee, stated: “I expect it is not profitability? The answer is provided clearly by a monetary policy move. It won’t affect money sup- Greenspan. Again, the Financial Times summa- ply growth” (“Fed to cut reserve…” 1992). Meltzer rizes Greenspan’s perspective in his Humphrey- did not see this action as an expansionary monetary Hawkins testimony by stating that “the requirement policy move because of his expectation that the that banks hold non-interest-bearing reserves with expansionary effects of the reserve requirement the Fed amounted to a tax on banks” (“Greenspan reduction would be offset by contractionary open sees benefits…” 1992). This statement suggests that market operations. According to the American if banks do not have to hold as much in non-interest- Banker, Meltzer was not alone: “Most analysts earning reserves, they would likely either lend the think the Fed will use open-market operations to excess out or acquire new securities. In either case, sop up the reserves and keep interest rates about such action should increase interest income and where they are” (“Fed to cut reserve…” 1992). improve the profitability of banks because it would If further evidence is needed, one need only turn result in a larger asset base for which banks would to the words of the chairman of the Federal earn their spread.2 Reserve, Alan Greenspan. Two days after the Of course, recognizing that reserve requirements Federal Reserve announcement of the 1992 reserve can be viewed as a tax does not answer the ques- requirement reduction, Greenspan was testifying to tion, Who is going to gain when that tax is reduced? Congress in his semi-annual Humphrey-Hawkins There is a literature that suggests that depository monetary policy report. The Financial Times sum- institutions will attempt to pass the reserve require- marizes his report as upbeat, “predicting early eco- ment tax on to their customers. However, there is nomic recovery” (“Greenspan sees early…” 1992). some disagreement as to which customers, deposi- This economic backdrop would hardly appear to be tors or borrowers, bear the reserve requirement the appropriate stage for the introduction of a new tax. The following discussion describes the main expansionary policy initiative. The summary of the competing viewpoints on who bears the reserve testimony went on to state that Greenspan’s “bullish requirement tax. The box on page 44 illustrates the remarks about the economy may be interpreted as market reaction in each of these three cases to a further evidence that the Fed is not contemplating reduction in reserve requirements.
1. In his congressional testimony of March 13, 2001, Federal Reserve Governor Laurence Meyer makes a case for reserve requirements being useful for monetary policy purposes (1) if the Federal Reserve were allowed to pay interest on reserves, (2) if banks could pay interest on demand deposits, and (3) if the Fed had greater latitude than currently provided by Congress in altering reserve requirement ratios. In light of this reasoning, the arguments in this paper should not be over- generalized to suggest that reserve requirement changes would never be useful for achieving monetary policy objectives. 2. Furfine (2001) provides evidence that banks with higher profitability pay lower interest rates on federal funds loans.
Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 43 BOX Who Bears the Tax? Three Views on the Market Reaction to Changes in Reserve Requirement Ratios
any financial economists consider reserve the required reserve ratio. The nonreservable M requirements to be a tax on the financial rate is assumed to be exogenous, so bank demand institutions that issue reservable instruments. for reservable time deposits is perfectly elastic. Institutions that are required to hold reserves in Within this framework a reduction in reserve the form of vault cash or deposits with the Federal requirement ratios would result in an increase in Reserve forgo the opportunity cost of those funds yields on the reservable instruments. Chart A while they are held as required reserves because illustrates the reaction of CD yields to a decline in such funds are not available for loan or reinvestment reserve requirement ratios within the Fabozzi and therefore earn no return for the institution. and Thurston framework. The lower reserve While there is general consensus in the litera- requirement tax causes interest rates on reserv- ture that reserve requirements are a tax, there is able CDs to increase from i to i*. This higher rate widespread disagreement as to who bears the tax stimulates demand for reservable instruments as and who benefits when reserve requirement the demand curve shifts upward from D to D*. ratios are relaxed. Early work in this area, repre- sented by the first two theories described here, Bank Borrowers began with the assumption that financial institu- Fama (1985) and James (1987) independently tions would pass the reserve requirement tax on found no evidence of an inverse relationship to their customers. However, some believed the between reserve ratio changes and CD yields. tax would be passed on to depositors in the form Finding no evidence that the tax is passed on to of lower yields on reservable instruments while bank depositors, they infer that the tax must be others felt the tax would be passed to borrowers passed on to bank borrowers in the form of higher in the form of higher interest rates on loans. loan rates. This relationship is illustrated in Chart B, where a decline in the reserve requirement ratio Bank Depositors results in a decline in the cost of funds (from i to i*) Fabozzi and Thurston (1986) state that depos- to banks who are now willing to supply more loan- itors bear the reserve requirement tax in the form able funds (as represented by the supply curve of lower yields on reservable securities. They shift from S to S*). argue that rates on reservable instruments, for example, CDs, should be equal to the market- Bank Shareholders determined rate on otherwise identical non- More recent work in this area has focused on reservable instruments multiplied by one minus the reaction of bank stock prices to changes in
CHART A CHART B Reaction of CD Yields within the Fabozzi Relationship between Reserve Ratio and Thurston Framework Changes and Banking Lending Rates
Time deposits Loanable funds S i i i* D* S i i D i* S* Bank loan rates,
Reservable CD rates, D
q q* q q* Quantity of funds, q Quantity of funds, q
44 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 reserve requirements. While the previously dis- supply of outstanding bank equity shares is con- cussed theories assumed a partial equilibrium stant in the short run. So the overall impact of a framework in which banks would pass the reserve reserve ratio reduction is to increase the profitabil- requirement tax on to their customers, this theory ity and share prices of banks. acknowledges that the high level of competition in the deposit and loan markets, coupled with acces- CHART C sible substitutes for borrowers and lenders, might prohibit banks from passing the tax to customers. Stock Price Reaction In this case a change in reserve requirement ratios Bank equity shares would be inversely related to bank profitability because bank profitability would be lower when S reserve requirement ratios are high and vice versa. Chart C illustrates the impact of a reserve P requirement reduction within the context of this theory. Lower reserve requirements lead market P* participants to expect an increase in bank profits. P Bank equity shares become more desirable to market participants as profit expectations are
revised upward. This expectation of increased Bank stock prices, D* bank profitability leads to an increased demand D for bank equity shares as the demand curve shifts from D to D*, resulting in an increase in bank stock prices (from P to P*). Since the market is expected q to adjust profit expectations rapidly following an Quantity of shares outstanding, q announced change in reserve requirements, the
Black (1975) and Fabozzi and Thurston (1986) increases (reductions) in reserve requirements lead argue that the reserve requirement tax is passed on to lower (higher) bank stock prices. to depositors of reservable instruments in the form Kolari, Mahajan, and Saunders (1988) suggest that of lower yields. As such, the 1992 reduction in this reserve requirement changes, when they are viewed tax should have coincided with an associated as being permanent, can have significant effects on increase in yields on deposits. Fama (1985) and bank stock prices. The researchers provide evidence James (1987), however, find no evidence that past that increases in reserve requirements resulted in changes in reserve requirements resulted in changes lower returns to bank holding company stocks than to in yields on deposits. Given this lack of evidence, the market as a whole for the 1972–81 period. they infer that the reserve requirement tax is passed Slovin, Sushka, and Bendeck (1990) add to this on to bank borrowers in the form of higher interest evidence by considering the impact of reserve rates on loans. In the case of a reserve requirement requirement changes on equity returns for banks reduction, as in 1992, the tax burden is lowered, and over the 1972–86 period. This study also examines Fama and James would predict a decline in lending the impact of these changes on the equity returns for rates passed on to bank borrowers. manufacturing, communications, public utilities, and However, there still might be another bearer of the nonbank financial firms. The evidence supports the reserve tax burden. There is much recent evidence proposition that reserve requirements are a tax on suggesting that at least a portion of the tax is not depository institutions because bank equity prices passed on to borrowers or depositors but rather is change in response to reserve requirement changes. passed on to, or absorbed by, bank shareholders. Slovin, Sushka, and Bendeck also find little evidence Kolari, Mahajan, and Saunders (1988); Slovin, of monetary policy effects as manufacturing, com- Sushka, and Bendeck (1990); Osborne and Zaher munications, and public utility returns exhibit no (1992); Cosimano and McDonald (1998); and Stewart reaction to reserve requirement changes, suggesting and Hein (2002) all provide evidence suggesting that that there are few macroeconomic effects from these
Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 45 changes. But the study does find that nonbank finan- bank stock returns. Viewing a reserve requirement cial firms’ equity returns react in an opposite manner ratio change as solely a monetary policy move to the announced reserve requirement changes com- ignores this influence on depository institutions. It pared to bank returns. This evidence is interpreted would behoove us to broaden the characterization to mean that the reserve requirement tax actually of reserve requirement changes and understand shifts financial activity between the banking and that the Federal Reserve appears to change reserve nonbanking financial sectors. requirements for reasons other than influencing mon- Osborne and Zaher (1992) provide evidence that etary policy and that these changes have a direct announcements of reserve requirement changes impact on bank stock returns. prior to the December 1990 reserve requirement change resulted in significant abnormal stock returns Evidence on the 1992 Reserve Requirement for large commercial banks, especially when time Ratio Changes and Perceived Bank Safety deposit, as opposed to demand deposit, reserve raditional discussions of reserve requirements requirements were changed. Stewart and Hein Tfrequently characterize these regulations as providing liquidity for financial institutions as they deal with depositors that wish to withdraw funds from their accounts. This characterization can be As Alan Greenspan has stated, greater reserve misleading. Bank reserves have traditionally been thought of as a source of liquidity for banks that requirements are likely to reduce the profit- allows them to meet the withdrawal needs of their ability of banks by increasing the proportion customers and reduce their overall risk of default. of nonearning assets they must hold. This perception may be true in the case of excess reserves, but it is false where required reserves are concerned. Required reserves do not provide any substantive liquidity because banks are required to replenish them prior to the end of a two-week (2002) and Cosimano and McDonald (1998) examine maintenance period if they are depleted below the the market reaction to the 1990 reserve requirement required level. So required reserves are more reduction, and both find evidence consistent with appropriately thought of as a liability to the institu- the expected profitability of banks increasing fol- tions holding them rather than an asset. lowing the reserve requirement reduction. The 1990 However, contrary to the conventional wisdom, reserve requirement reduction eliminated reserve increasing reserve requirements may ultimately requirements on large, nonpersonal time deposits increase the risk of financial institution failure. As and net eurocurrency liabilities. Stewart and Hein Alan Greenspan has stated, greater reserve require- find evidence of abnormal share price appreciation ments are likely to reduce the profitability of banks for bank shareholders following the announcement by increasing the proportion of nonearning assets of the reduction. However, they find no evidence of they must hold. Moreover, greater reserve require- any reaction in stock returns in the utility, commu- ments reduce financial institutions’ true liquidity and nication, nondepository credit, broker-dealer, or correspondingly increase their total cost of short- insurance industries. Cosimano and McDonald also term funds, again leading to a reduction in bank prof- consider the 1990 reduction of reserve require- itability. Also, with a given dividend payout policy for ments on eurodollar liabilities and nonpersonal time the bank, reduced profitability means that additions deposits. They find positive abnormal returns for to equity capital will be lower and banks will not be large commercial banks around the time of the as well capitalized as they would have been. announcement. They also find a significant positive Thus, there appear to be two competing theories relationship between the size of the bank and the as to how reserve requirement changes might affect magnitude of abnormal returns. the perceived risk of financial failure for depository In summary, there is increased recognition that institutions. To shed light on which of these two reserve requirements can best be thought of as a tax, theories seems to be most consistent with the data, but there is also considerable disagreement as to who we examine the relative movement of short-term ultimately bears this tax. The majority of the most interest rates following the February 18, 1992, recent empirical work in this area provides consid- Federal Reserve announcement that the reserve erable evidence to suggest that changes in reserve requirement ratio on net transaction deposits would requirement ratios represent significant events for be reduced from 12 percent to 10 percent for deposit
46 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 CHART 1 Three-Month CD and Eurodollar Rates
18 CD rate ED rate 16
14
12
10
8 Percentage rate 6
4
2
0 1970 1975 1980 1985 1990 1995 2000
Source: Federal Reserve Bank of St. Louis FRED® database,
3. The TED spread is traditionally defined as the Treasury bill futures price minus the eurodollar futures price. As both futures prices are 100 minus the respective interest rate, the TED spread can equivalently be represented as the eurodollar interest rate minus the Treasury bill rate.
Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 47 TABLE Mean Treasury Bill, Eurodollar Futures, and TED Spread Rates before and after the 1992 Reserve Requirement Change Announcement: Mann-Whitney Test
Mean before Mean after Mann- Maturity (Feb. 13–14, 1992) (Feb. 18–19, 1992) Whitney Series (in 1992) percentage percentage statistic p-value
TBR June 3.920 3.983 7.0 .0607 TBR Sept. 4.215 4.280 7.0 .0607 TBR Dec. 4.750 4.820 7.0 .0607 EDR June 4.390 4.410 6.5 .1104 EDR Sept 4.775 4.800 6.5 .1104 EDR Dec. 5.475 5.505 7.0 .0607 TED June 0.470 0.445 7.0 .0607 TED Sept. 0.560 0.535 7.0 .0607 TED Dec. 0.725 0.695 7.0 .0607
Note: TBR is the rate on Treasury bill futures contracts, EDR is the rate on eurodollar futures contracts, and TED is the difference between the rate on eurodollar futures contracts and Treasury bill futures contracts. Source: Tick Data, Inc. in reserve requirements. Depositors would require move were truly an indication of expansionary mon- higher interest rate compensation to bear the etary policy, one would expect short-term interest increased risk that the institution would fail and rates to fall. For all three maturities, the Treasury they would be unable to get their deposits back in bill futures interest rate increased significantly (at full. Such a finding would be consistent with a higher the 10 percent level) following the announcement. On premium on eurodollar deposit yields relative to average, the Treasury bill rates were almost 7 basis Treasury securities. points higher for the two days following the announce- We gathered daily closing interest rates on the ment than for the two prior business days. Treasury bill and eurodollar futures contracts for Chart 2 further shows that the increase in the three different contract delivery dates (June, Sep- Treasury bill futures rates continued over the next tember, and December 1992), all maturing after the couple of weeks as well. It is unclear whether or not reserve requirement reduction was fully in place. We one should associate the subsequent Treasury bill rate gathered the interest rates for these contracts around increases with the reserve requirement announce- the time of the Federal Reserve announcement. ment. On the one hand, if this market is truly efficient, Since the announcement was made on February 18, as most believe, there should not be any delayed we compare the average TED, EDR, and TBR two response to information releases such as this. On the days before the announcement (February 13 and 14) other hand, the change in reserve requirements is and two days after the announcement (February 18 not a very frequent event, and, as we have argued in and 19) for each of the maturities.4 A relatively short this article, there is not a clear consensus on how window is used because we have no clean way of reserve requirement changes should affect deposi- controlling for other events that may impact short- tory institutions and the financial markets within term interest rates. The Mann-Whitney test statistic which they operate. Regardless, there is no evidence is used because of the relatively few distributional here to suggest that the change resulted in lower assumptions required. short-term interest rates because the Treasury bill The table provides the various two-day means of rate on these three futures contracts clearly rose our two short-term interest rate futures contracts after the announcement. and the TED spread, as well as our test statistics, The table further shows that eurodollar futures for the two business days before the announcement rates also increased for all three maturities. But and the two business days immediately after the here the increase was neither as large (nor as sta- announcement. The first thing to note is that short- tistically significant) as the increase in Treasury bill term interest rates generally rose following the futures rates. On average, the eurodollar futures announcement. Such an occurrence is consistent rates were only about 3 basis points higher follow- with the view that the announcement was not an ing the announcement. This increase was not sta- example of expansionary monetary policy. If the tistically significant at the 10 percent level for the
48 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 CHART 2 Treasury Bill Futures Rates, Two-Day Intervals, February 1992
6 TB June 1992 TB Sept. 1992 Reserve requirement change TB Dec. 1992 5
4
3 Percentage rate 2
1
0 2/03–04 2/05–06 2/07–10 2/11–12 2/13–14 2/18–19 2/20–21 2/24–25 2/26–27 1992 1992 1992 1992 1992 1992 1992 1992 1992
Source: Tick Data, Inc.
June and September 1992 contracts but was signif- theory supported by the data. First, in most cases, icant at the 10 percent level for the December 1992 the eurodollar futures rate increased by a very small contract. Chart 3 also shows that the increase in and statistically insignificant magnitude. However, eurodollar rates continued over the next few days, more importantly, Fabozzi and Thurston suggest similar in direction to the change in the Treasury bill that deposit rates should rise relative to nondeposit futures rates but changing by smaller magnitudes. interest rates. On this point, their theory is not sup- The theoretical framework of Fabozzi and ported because nondeposit rates rose more than Thurston (1986), as outlined in the previous sec- deposit rates following the announcement. tion, states that the reserve requirement tax would We now consider the relative moves in rates, as be borne by depositors. Since current law prohibits measured by the TED spread, a measure of relative paying interest on demand deposits, we ask if other financial risk. The table shows that the TED spread bank depositors were provided higher interest rates declined significantly (at the 10 percent level) for all as a result of the 1992 cut in the reserve require- three maturities. On average, the TED spread was ment on transaction deposits. We use the eurodollar about 3 basis points smaller after the announce- interest rate to proxy the explicit interest paid to ment. Since both rates increased, the decline in the bank depositors. The Fabozzi and Thurston frame- TED spread indicates, as detailed above, a relatively work would suggest that, in the case of a reserve larger rate increase for Treasury bills than for requirement reduction, deposit rates should rise. On eurodollar deposits. This finding is inconsistent with this point, their framework would appear to be sup- the view that the decrease in reserve requirements ported by the data as, indeed, the eurodollar rates resulted in greater concerns about the default rose in 1992 following the announced reduction. potential for depository institutions. In fact, the find- Two important issues prevent us from declaring the ings are more consistent with the view that reserve
4. February 13 and 14, 1992, were a Thursday and Friday, respectively. Financial markets were then closed on the weekend, February 15 and 16, and remained closed on President’s Day, February 17. Thus, the announcement was made on Tuesday, February 18. To assure that there were no other significant events that might have caused movements in these short-term interest rates, we did a Wall Street Journal search, which revealed no other events with obvious implications for these short- term rates and the TED spread.
Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 49 CHART 3 Eurodollar Futures Rates, Two-Day Intervals, February 1992
6 EDR June 1992 Reserve requirement change EDR Sept. 1992 EDR Dec. 1992 5
4
3 Percentage rate 2
1
0 2/03–04 2/05–06 2/07–10 2/11–12 2/13–14 2/18–19 2/20–21 2/24–25 2/26–27 1992 1992 1992 1992 1992 1992 1992 1992 1992 Source: Tick Data, Inc. requirements might impair the safety and soundness requirement reduction on nonpersonal time deposits of financial institutions. and eurodollar borrowings. In this case, both rates The 3 basis point reduction in the TED spread is also increased after the announcement, and the TED admittedly small, but the economic significance of spread declined, but by a larger magnitude than this change should not be minimized. Each 1 basis documented above. point move in either the Treasury bill futures con- The evidence on the TED spread is inconsistent tract or the eurodollar futures contract translates with the conventional wisdom that reserve require- into a $25 change in the value of the contract. Thus, ments make depository institutions safer. Indeed, the 3 basis point move in the TED spread would the evidence suggests the opposite is more likely to translate into a $75 change in value. Moreover, the be the case, with lower reserve requirements result- margin for taking a position in the TED is generally ing in depository institutions that are perceived as quite small as the TED spread itself is far less safer because of increased profit potential. volatile than the two separate futures contracts. Being on the right side of this move in the day could Conclusions and Implications have easily yielded a 25 percent return on a two-day n application of the basic principles of most position, for example, if the initial margin on estab- A money and banking textbooks to predict the lishing a TED position were $300. outcome of the 1992 reduction in reserve require- Chart 4 shows that the reduction in the TED ments on transaction deposits would be in error spread documented in the table also continued over on certain points and misleading on others. First, the next few trading days. By the end of February, most textbooks would categorize the change as the TED spread had fallen by some 9 to 12 basis an example of expansionary monetary policy. points from the peak observed the two days prior to However, as indicated in this article, short-term the reserve requirement announcement. Over the interest rates generally rose after the announce- more extended period, the economic significance of ment rather than fell, as an expansion in monetary the reduction in the TED spread is thus even larger policy would suggest. Thus, the predicted change than detailed above. suggested by most textbooks in the area would be Finally, we should note that Stewart and Hein in error. Second, textbook discussions would gen- (2002) document very similar behavior of these two erally ignore the impact that the change was likely short-term interest rates following the 1990 reserve to have on bank stock prices. However, according
50 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 CHART 4 TED Spread, Two-Day Intervals, February 1992
0.8 TED June 1992 TED Sept. 1992 Reserve requirement change TED Dec. 1992 0.7
0.6
0.5
0.4
Percentage rate 0.3
0.2
0.1
0 2/03–04 2/05–06 2/07–10 2/11–12 2/13–14 2/18–19 2/20–21 2/24–25 2/26–27 1992 1992 1992 1992 1992 1992 1992 1992 1992
Source: Tick Data, Inc. to statements of Federal Reserve officials, the 1992 change as increasing the riskiness of depository reserve requirement change was intended to institutions, as tradition might suggest. improve the anticipated profitability of depository This article argues that reserve requirement institutions. Moreover, there is extensive evidence ratio changes should not be viewed simply as a tool indicating that prior changes in reserve require- for monetary policy or as a tool used to directly ments were associated with subsequent changes alter the liquidity of financial institutions. This view in bank stock returns. Textbook emphasis on mon- raises the question, What is the purpose of the etary policy considerations would have ignored reserve requirement ratio? We believe that the this impact altogether. value of reserve requirements, as a source of liquid- Finally, from a regulatory perspective, reserve ity or a tool of monetary policy, is indeed recognized requirements are traditionally viewed as making today to be less than previously thought by many depository institutions relatively safer. Thus, a central banks. As evidence in support of this view, reduction in these requirements should suggest some central banks—such as those in Canada, greater concerns about the financial health of such Great Britain, and New Zealand—have recently institutions. Yet evidence in this article indicates eliminated cash reserve requirements altogether.5 that the exact opposite occurred. Following the Even in the United States, the Federal Reserve has 1992 announcement of the reserve requirement recently allowed depository institutions to reduce reduction, the TED spread—a traditional proxy for the cost of reserve requirements by sweeping the risk of deposit institutions—narrowed signifi- reservable accounts into nonreservable accounts.6 cantly rather than increased. This outcome sug- Thus, one could argue that reserve requirements gests to us that financial markets did not view the have effectively been reduced in the United States.7
5. Sellon and Weiner (1997) describe the reserve requirement structure in these countries and the implementation of monetary policy therein. 6. Anderson and Rasche (2001) provide a good description of such sweep programs and the extent to which they have reduced effective reserve requirements. Bennett and Peristiani (2002) ask the broader question of whether today’s reserve require- ment structure requires institutions to hold more in reserve than they would voluntarily. 7. Haslag (1998) discusses the role of seigniorage—the revenues earned from creating new money—in monetary policy. Haslag looks internationally, across countries, to assess the typical reliance on seigniorage revenue. He finds that countries with com- binations of high rates of money growth and high reserve requirements tend to rely especially heavily on seigniorage revenue.
Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2002 51 REFERENCES
Anderson, Richard G., and Robert H. Rasche. 1996. A Haslag, Joseph H., and Scott E. Hein. 1989. Reserve revised measure of the St. Louis adjusted monetary base. requirements, the monetary base, and economic activity. Federal Reserve Bank of St. Louis Review 78 (March/ Federal Reserve Bank of Dallas Economic Review April): 3–13. (March): 1–15. ———. 2001. Retail sweep programs and bank reserves, James, Christopher. 1987. Some evidence on the unique- 1994–1999. Federal Reserve Bank of St. Louis Review 83 ness of bank loans. Journal of Financial Economics (January/February): 51–72. 19:217–35. Bennett, P., and S. Peristiani. 2002. Are U.S. reserve Kolari, James, A. Mahajan, and E.M. Saunders. 1988. The requirements still binding? Federal Reserve Bank of effect of changes in reserve requirements on bank stock New York Economic Policy Review 8 (May): 53–68. prices. Journal of Banking and Finance 12:183–98. Black, Fisher. 1975. Bank funds management in an effi- Meyer, Laurence H. 2001. Payment of interest on cient market. Journal of Financial Economics 2:323–39. reserves. Testimony before the Financial Services Sub- committee on Financial Institutions and Consumer Credit, Cosimano, Thomas F., and B. McDonald. 1998. What’s U.S. House, March 13, 2001.
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