Variable Reserve Requirements Against Commercial Bank Deposits Richard Goode and Richard S. Thorn * IXED LEGAL OR CUSTOMARY RESERVES against deposits Fhave long been employed for the purpose of assuring the liquidity or solvency of commercial banks. These reserves, of course, limit the availability of bank credit and thus have important implications for monetary policy. As long as the reserve ratios are not subject to change by the monetary authorities, however, reserve requirements cannot be actively used as an instrument for carrying out a stabilizing mone- tary policy flexibly adjusted to changing conditions. In the past two decades, and particularly in the postwar period, the potentialities of variable reserve requirements as an instrument of monetary policy have come to be widely recognized, and many countries have given the monetary authorities power to vary reserve requirements against commercial bank deposits. The purposes of the present study -are (1) to examine the functions of variable reserve requirements; (2) to consider objections to variable reserve requirements and limitations on their proper use; (3) to describe the conditions in which reserve requirements have been, or may be, changed; and (4) to examine technical questions relating to the form and operation of variable reserve requirements. The status of the reserve requirements in various countries is summarized in Appendix II. Functions of Variable Reserve Requirements LIMITATION OF THE QUANTITY OF BANK CREDIT Reserve requirements determine the maximum amount of loans and investments that each commercial bank, and the banking system as * Mr. Goode, Assistant Director of the Asian Department, was formerly Chief of the Finance Division. Before joining the Fund staff he was assistant professor of economics at the University of Chicago and economist at the U.S. Bureau of the Budget and the U.S. Treasury Department. Mr. Thorn, economist in the Finance Division, is a graduate of Columbia Col- lege, the University of Maryland, and Yale University. He is temporarily assigned to the European Office of the International Monetary Fund in Paris. 9 10 INTERNATIONAL MONETARY FUND STAFF PAPERS a whole, may maintain in relation to deposits. Thus, if the reserve requirement is 20 per cent of deposits, loans and investments (of the bank's own choosing) may not exceed 80 per cent of deposits.1 Reserve requirements therefore limit the total expansion of bank credit and the secondary expansion of bank deposits that can occur on the basis of any primary increase in deposits.2 Reserve requirements also have the effect of limiting the reduction in bank credit and deposits that is forced upon the banking system by a primary decrease in deposits. Looked at from another point of view, it can be seen that reserve requirements limit the extent to which bank loans and in- vestments can, or must, change when there is an increase or de- crease in the cash resources of banks as a result of rediscounts at the central bank or a change in another nondeposit item in the balance sheet. This is true because the extension or contraction of bank loans and investments results in the creation or extinction of deposits and hence in an increase or decrease in the amount of required reserves. These functions can be performed by several types of reserve re- quirement, but they are clearest in connection with a cash reserve requirement that the commercial banks discharge by maintaining de- posits at the central bank. Attention will first be given to this type of requirement, which is not only the simplest but also the most common. Primary changes in bank deposits come about most often as the re- sult of a balance of payments surplus or deficit, or the extension or contraction of central bank loans or investments. These phenomena create or destroy "reserve money"—which consists of currency and deposits at the central bank and which has the capacity to satisfy the cash reserve requirements of the commercial banks. The government can influence the quantity of reserve money by shifting its deposits between the commercial banks and the central bank. In some countries the government can also increase or decrease the amount of reserve money by issuing or withdrawing treasury currency, but at the present time in most countries the amount of treasury currency is small com- pared with central bank currency. Bank deposits may change, without any change in the amount of reserve money, if the public decides to hold more or less deposits relative to currency. In addition to legal reserves, a second important limitation on the capacity of the banking system to expand on the basis of a primary 1 The banks can also extend loans and investments that are financed out of bank capital and surplus and borrowings, but in most countries these items are small compared with deposit liabilities. 2 A primary increase (or decrease) in deposits is an increase (or decrease) in deposits of the commercial banking system that is matched by an equal change in the central bank's liabilities to the commercial banks. VARIABLE RESERVE REQUIREMENTS AGAINST BANK DEPOSITS 11 increase in deposits arises from withdrawals of currency by bank cus- tomers. Ordinarily, the public wishes to maintain a fairly constant relation between its deposits and currency holdings. When deposits in- crease, the demand for currency also increases. This may be called the currency drain. The commercial banks can obtain currency to pay out to customers only by drawing down their reserve deposits at the central bank or by using till money. Till money is the currency that banks keep on hand to satisfy day-to-day needs. In some countries till money is included, along with deposits at the central bank, in legal reserves, but in other countries its provision places a third limitation on the capacity of banks to expand loans and investments. Till money, how- ever, is usually small relative to deposits and it will not be further considered in the following exposition. Another limitation on the growth of money supply that is highly important in many countries is the "external drain." This is the withdrawal of money from circula- tion that occurs when a balance of payments deficit is caused by a rise in imports and a fall in exports resulting from an expansion of credit and money income.3 In this paper it is considered convenient to analyze the effects of reserve requirements without allowance for the external drain, since the control of the balance of payments (and hence indirectly of the external drain) is usually an objective of monetary policy and can be furthered by measures that influence the quantity of reserve money and the secondary credit expansion that can be based on it. Since bank deposits are a large part of the money supply in virtually all countries, reserve requirements have an important influence on the extent to which the money supply can expand as a result of a balance of payments surplus, a central-bank-financed fiscal deficit, or any other development that brings about an increase in reserve money. The higher the required reserve, the smaller the maximum expansion. A high required reserve likewise diminishes the extent to which the money supply must contract as a result of a reduction in reserve money. A high ratio of currency to total money supply also restricts the capacity of the banking system to expand loans and investments and thus to increase the money supply on the basis of an injection of re- serve money or an increase in the banks' cash resources through re- discounting with the central bank. These relations are set forth in a formal way in Appendix I. Table 1 shows how the size of the potential expansion of money supply in response to an injection of reserve money (expressed as a multiple of the increase of reserve money) is 3 See J. J. Polak, "Monetary Analysis of Income Formation and Payments Problems," Staff Papers, Vol. VI (1957-58), pp. 1-50. 12 INTERNATIONAL MONETARY FUND STAFF PAPERS determined both by the magnitude of the minimum required reserve ratio and by the proportion of the actual increase in money supply that takes the form of currency.4 It will be observed that, whenever either marginal reserve requirements or the ratio of currency to money supply is 100 per cent, no secondary expansion of the money supply is possible. TABLE 1 Proportion of Increased Money Supply That Appears as Minimum Currency zero 25 per cent 50 per cent 100 per cent Required Reserve Ratio 10 per cent 10.0 3.1 1.8 1.0 25 per cent 4.0 2.3 1.6 1.0 50 per cent 2.0 1.6 1.3 1.0 100 per cent 1.0 1.0 1.0 1.0 The authorities have little if any control over the proportion of cash balances that the public chooses to hold in the form of currency, but in many countries they can control the banks' reserve ratio. By imposing a high required reserve ratio, the authorities can limit the inflationary effect of a government deficit, a balance of payments sur- plus, or any other development that brings about an increase in reserve money. The existence of a high reserve ratio can cushion the shock of a reduction of reserve money, because a large fraction of the loss will be reflected in a decrease in required reserves rather than in bank credit, and the contraction of money supply will be smaller than it would be with a low reserve ratio. A high fixed reserve requirement, therefore, can be an important stabilizing force by virtue of the fact that it reduces the secondary credit expansion or contraction that occurs on the basis of a primary change in reserve money.