Reserve requirements history, current practice, and potential reform

Reserve Requirements: History,Current Practice, and Potential Reform

Joshua N. Feinman, of the Board’s Division ofMonetary Affairs, prepared this article. JanaDeschler and Christoph Hinkelmann providedresearch assistance.

Laws requiring banks and other depository institu-tions to hold a certain fraction of their deposits inreserve, in very safe, secure assets, have been a partof our nation’s banking history for many years. Therationale for these requirements has changed overtime, however, as the country’s financial systemhas evolved and as knowledge about how reserverequirements affect this system has grown. Beforethe establishment of the Federal Reserve System,reserve requirements were thought to help ensurethe liquidity of bank notes and deposits, particu-larly during times of financial strains. As bank runsand financial panics continued periodically toplague the banking system despite the presence ofreserve requirements, it became apparent thatthese requirements really had limited usefulness asa guarantor of liquidity. Since the creation of theFederal Reserve System as a lender of last resort,capable of meeting the liquidity needs of the entirebanking system, the notion of and need for reserverequirements as a source of liquidity has all butvanished. Instead, reserve requirements haveevolved into a supplemental tool of monetarypolicy, a tool that reinforces the effects of openmarket operations and discount policy on overallmonetary and credit conditions and thereby helpsthe Federal Reserve to achieve its objectives.

While useful as an auxiliary policy tool, reserverequirements also have important implications forthe efficacy of the Federal Reserve’s primary tool,open market operations. In the early 1980s, forexample, when open market operations weregeared toward fostering fairly precise, short-runcontrol of narrowly defined money (M1), reserverequirements were designed to help facilitate thiscontrol by establishing a relatively stable, contem-

poraneous link between reserves and M1 deposits.Although the Federal Reserve is no longer pursuingthis type of short-run control of money, reserverequirements still play an important role in theconduct of open market operations, which are nowaimed at influencing general monetary and creditconditions by varying the cost and availability ofreserves to the banking system. By helping toensure a stable, predictabledemand for reserves,reserve requirements better enable the FederalReserve to achieve desired reserve market condi-tions by controlling thesupply of reserves; in sodoing, they help prevent potentially disruptive fluc-tuations in the money market.

Reserve requirements are not costless, however.On the contrary, requiring depositories to hold acertain fraction of their deposits in reserve, eitheras cash in their vaults or as non-interest-bearingbalances at the Federal Reserve, imposes a cost onthe private sector equal to the amount of forgoneinterest on these reserves—or at least on the frac-tion of these reserves that banks hold only becauseof legal requirements and not because of the needsof their customers. The higher the level of reserverequirements, the greater the costs imposed on theprivate sector; at the same time, however, higherreserve requirements may smooth the implementa-tion of monetary policy and damp volatility in thereserves market.

The Federal Reserve could resolve this policydilemma by paying interest on required reserves, orat least on the part of these reserves that bankswould not hold were it not for legal requirements.Paying an explicit, market-based rate of return onthese funds would effectively eliminate much ofthe costs of reserve requirements without jeopardiz-ing the stable demand for reserves that is neededfor open market operations and for the smoothfunctioning of the reserves market.

The Federal Reserve Board has long supportedlegislation that would explicitly allow interest to be

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paid on the balances that depositories are requiredto hold in reserve—though not on the cash theyhold in their vaults, which is assumed to be heldprimarily to meet customer needs—but to no avail.1

Opposition has typically centered on the adverseimplications such a move would have for Treasuryrevenue. If the Federal Reserve paid interest onrequired balances, its net earnings would decline,and because it turns the vast majority of its earn-ings over to the Treasury, the Treasury’s revenueswould decline as well. On the other hand, eliminat-ing the costs of reserve requirements would removeone government-mandated impediment to deposit-taking and lending through the banking system.Recently, the costs of depository intermediationhave risen sharply because of higher deposit insur-ance premiums, stiffer capital requirements, morestringent standards for interbank lending, and otherregulatory burdens. Much of these increased costshave likely been passed on to the customers ofdepositories in the forms of higher loan rates andlower deposit rates; paying interest on reserveswould be one way of countering some of thesegovernment-mandated increases in costs.

BASIC CONCEPTS AND CURRENT RULES OFRESERVE REQUIREMENTS

Under current regulations, all depositoryinstitutions—commercial banks, savings banks,thrift institutions, and credit unions—are required

to maintain reserves against transaction deposits,which include demand deposits, negotiable orderof withdrawal accounts, and other highly liquidfunds.2 Reserves against these deposits can take theform either of currency on hand (vault cash) orbalances at the Federal Reserve. The FederalReserve may vary the percentage of transactiondeposits that must be kept in reserve, but onlywithin fairly narrow limits prescribed by law;requirements may also be imposed on certain typesof nontransaction accounts, though again onlywithin specified limits.3 At present, the requiredreserve ratio on nontransaction accounts is zero,while the requirement on transaction deposits is10 percent, which is near the legal minimum.

Most depositories are able to satisfy their entirereserve requirement with vault cash, which theyhold primarily to meet the liquidity needs of theircustomers and would likely hold even in theabsence of reserve requirements. For these institu-tions, reserve requirements are essentially costless.About 3,000 depositories, however, have vault cashholdings that are insufficient to satisfy their entirereserve requirement. To meet their requirements,these institutions must also maintain deposits,called required reserve balances, at the FederalReserve.

Reserve Requirements as a Tax

Some uncertainty exists as to whether the FederalReserve Act permits interest to be paid on reserves.In fact, the Federal Reserve has never actually paid

1. See, for example, ‘‘ Statement by Arthur F. Bums, Chairman,Board of Governors of the Federal Reserve System, before theSubcommittee on Financial Institutions of the Committee on Bank-ing, Housing, and Urban Affairs, U.S. Senate, June 20, 1977,’’Federal Reserve Bulletin, vol. 63 (July 1977), pp. 636–43; ‘‘ State-ment by J. Charles Partee, member, Board of Governors, before theSubcommittee on Financial Institutions Supervision, Regulationand Insurance of the Committee on Banking, Finance and UrbanAffairs, U.S. House of Representatives, October 27, 1983,’’ FederalReserve Bulletin, vol. 69 (November 1983), pp. 840–52; and‘‘ Statement by Alan Greenspan, Chairman, Board of Governors ofthe Federal Reserve System, before the Subcommittee on DomesticMonetary Policy of the Committee on Banking, Finance and UrbanAffairs, U.S. House of Representatives, February 19, 1992,’’ Gov-ernment Printing Office, Serial No. 102-98 (1992), pp. 42–43. TheFederal Reserve has also requested the lifting of the prohibition onthe payment of interest on demand deposits. See, in particular, thestatement by J. Charles Partee, October 27, 1983.

2. For a formal definition of depository institutions and transac-tion accounts, see Federal Reserve Regulation D (Reserve Require-ments of Depository Institutions), sections 204.1 and 204.2.

3. At present, required reserve ratios may be set between 8 per-cent and 14 percent on transaction accounts in excess of $46.8 mil-lion, and between 0 and 9 percent on nonpersonal savings deposits,nonpersonal time deposits with original maturities of eighteenmonths or longer, and net Eurocurrency liabilities. Transactiondeposits of less than $46.8 million, in the so-called low reservetranche, are reservable at 3 percent, while the first $3.8 million oftransaction deposits at each depository are exempt from reserverequirements altogether. The Federal Reserve cannot alter the cut-offs for the low reserve tranche or the exemption, which areadjusted each year according to a formula provided by law.

570 Federal Reserve Bulletin June 1993



interest on required reserve balances.4 Requiringdepositories to hold idle, non-interest-bearing bal-ances is essentially like taxing these institutions inan amount equal to the interest they could haveearned on these balances in the absence of reserverequirements. This forgone interest, or reserve‘‘ tax,’’ directly affects only the depository systemand its customers, and not other parts of the finan-cial system. Hence, it creates an artificial incentivefor depositors and borrowers to bypass the deposi-tory system, and in so doing it may redirect creditflows in ways that impair the efficiency of resourceallocation. In particular, by distorting the relativeprice of transaction accounts at depositories, thereserve tax may induce a smaller level of transac-tion services than what would be ideal for thefunctioning of the economy. The reserve tax alsocreates an incentive for depositories to expendresources trying to minimize required reserves byfashioning new financial products aimed solely atdelivering transactions services without creatingreservable liabilities.

As is true for most taxes, determining preciselywho bears the burden of the reserve tax is difficult.That determination depends in a complicated wayon the degree of competitive pressure in the mar-kets for deposits and loans and the associated sensi-tivities of borrowers, lenders, and depositories tochanges in prices and interest rates. One thing iscertain, however: Depositories and their sharehold-ers do not bear all of the costs but rather pass atleast some of them on to their customers in theforms of lower deposit rates and higher loan rates.In compensating-balance arrangements, for exam-ple, in which customers maintain non-interest-bearing deposits as compensation for bank ser-vices, the customers typically ‘‘ pay’’ the reservetax by holding additional balances. Similarly, to theextent that some borrowers, such as small and

medium-sized businesses, have few alternativesoutside of the depository system, these borrowersmay ultimately bear some of the burden of thereserve tax in the form of higher costs of credit.

Current Estimates of the Reserve Tax

Table 1 presents estimates of the current dollarmagnitude of the reserve tax. In the fourth quarterof 1992, the required reserve balances of all deposi-tories totaled $231⁄2 billion. Because many of thefinancial transactions in our economy flow throughthese reserve accounts, even in the absence ofreserve requirements depositories would likely holdsome balances at the Federal Reserve as a bufferagainst the normal uncertainties surrounding pay-ment flows. Thus, $231⁄2 billion should be consid-ered an upper bound on the amount of balancestruly idled by reserve requirements in the fourthquarter of 1992. Even if banks had invested all ofthese funds, moreover, the gains would probablynot have been large because short-term interestrates are currently at relatively low levels. Using afederal funds rate of 3 percent as a proxy for thepotential earnings rate on idle balances, the lostinterest income due to reserve requirements totalsonly about $700 million, at an annual rate, basedon $231⁄2 billion of balances. About $600 millionof this would have accrued to commercial banksand their customers; even in the unlikely event thatbanks were able to retain all of this increasedrevenue, it would have boosted their pretax returnon assets for 1992 by only about 2 basis pointscompared with an actual pretax rate of return onassets of a little more than 130 basis points.

On an after-tax basis, the earnings would be evensmaller because depositories and their customerswould have to pay extra taxes on this additionalincome. Regardless of the precise figure, however,

4. The Federal Reserve Board has, however, at least in the past,taken the position that it has the discretion to pay interest onreserves, though individual members of the Congress opposed suchpayments at the time of the enactment of the Federal Reserve Actin 1913 and again as recently as 1978. For details on a FederalReserve proposal to pay interest on required reserve balancesin 1978, see Federal Reserve Bulletin, vol. 64 (July 1978),pp. 605–10. For congressional reaction to this proposal, see, ‘‘ Mone-tary Control and the Membership Problem,’’ Hearings before theCommittee on Banking, Finance and Urban Affairs on H.R. 13476,H.R. 13477, H.R. 12706, and H.R. 14072, 95 Cong. 2 Sess. U.S.House of Representatives (GPO, 1978), p. 781.

1. Burden of reserve requirements, 1992:Q4Billions of dollars

Type ofinstitution

Requiredreserve balances

Forgoneinterest

All depositories . . . . . . . . . . . . . 23.5 .7

Commercial banks . . . . . . . . . . . 21.1 .6Thrift institutions . . . . . . . . . . . . 2.4 .1

1. Forgone interest is annualized, based on a federal funds rate of3 percent.

Reserve Requirements: History, Current Practice, and Potential Reform 571



if the Federal Reserve paid interest on all requiredreserve balances, the private sector would enjoy anet increase in after-tax income, whereas the Trea-sury would see its net revenues reduced. Of course,if interest rates were higher, the burden of reserverequirements and the private-sector cost savingsand government revenue losses stemming frompaying interest on required reserve balances wouldbe commensurately larger than the amounts shownin table 1. The distortions to resource allocationwould be more pronounced as well. Indeed, theburden of reserve requirements has, at times, beenconsiderably larger than it is now, as a result ofboth higher interest rates and higher reserverequirements.

Because reserve requirements are a tax on theprivate sector that may distort the optimal alloca-tion of resources in the financial sector, the ques-tion arises as to why these requirements wereimposed in the first place. The next section tracesthe historical evolution of reserve requirements andtheir rationales to see how our current systemdeveloped. Subsequently, several options forreforming the current system to eliminate thereserve tax without jeopardizing the effective con-duct of monetary policy are analyzed.

HISTORICAL REVIEW OF RESERVEREQUIREMENTS AND THEIR RATIONALES

Reserve requirements have played a part in ournation’s financial system from the earliest days—long before the creation of a national currency or acentral bank.

Early State Laws and Practices

The first commercial banks in this country werechartered by the states and were not required tokeep reserves either against deposits, which werelittle used at the time, or against their own, moreubiquitous, bank notes. In the absence of a nationalcurrency, bank notes were commonly used as amedium of exchange, though high transaction costsof redeeming the notes and limited informationabout the underlying solvency of the issuer gener-ally confined the use of any individual bank’s notesto a small geographic area. To facilitate the morewidespread use of their notes, banks in New York

and New England entered into voluntary redemp-tion arrangements as early as 1820. Under thesearrangements, one bank agreed to redeem anotherbank’s notes at par, provided that the issuing bankmaintained a sufficient deposit of specie (gold or itsequivalent) on account with the redeeming bank asbacking for the notes. In essence, these depositsrepresented the first required reserves. The primarypurpose of these reserves was to increase theliquidity of bank notes by ensuring their convert-ibility into specie. Although in subsequent yearssome states began to require banks to maintainreserves against their notes, and a few even beganto require reserves against deposits, most states stillhad no legal reserve requirements when the CivilWar broke out in 1861.

The National Bank Era

Reserve requirements were first established at thenational level in 1863 with the passage of theNational Bank Act. This act provided banks anopportunity to organize under a national charterand created a network of institutions whose notescould circulate more easily throughout the country.In exchange for this charter, banks had to holda 25 percent reserve against both notes anddeposits—a much higher requirement than thatfaced by most state banks. Although banks in‘‘ redemption’’ cities—designated in the act as citieswhere notes were likely to accumulate forredemption—had to hold reserves entirely in theform of ‘‘ lawful’’ money (specie or greenbacks),banks outside these cities could maintain 60 per-cent of their reserves in interest-bearing balances atbanks in redemption cities.

Reserve requirements were seen as necessary forensuring the liquidity of national bank notes andthereby reinforcing their acceptability as a mediumof exchange throughout the country. Concentratingreserves in areas where demands for liquidity werelikely to be most acute was thought to be the surestmeans of promoting the widespread use and accep-tance of national bank notes. At the same time,allowing banks outside redemption cities to earninterest on a portion of their reserves made theburden of reserve requirements less onerous forbanks that faced more limited demands forliquidity.




The federal government had a keen interest inseeing the use of national bank notes flourishbecause, in addition to reserve requirements,national bank notes were also required to bebacked by holdings of government bonds, whichwere needed to finance the Civil War. To make theissuance of national bank notes less costly, reserverequirements against these notes were lowered forbanks outside redemption cities from 25 percent to15 percent in 1864, and banks in redemption citiesoutside New York City were allowed to meet halfof their requirements with interest-bearing balancesat a bank in New York. Still dissatisfied with therate of growth of national bank notes, the Congressimposed a tax on state bank notes in 1865, effec-tively guaranteeing the primacy of national banknotes as a medium of exchange. Indeed, in subse-quent years, these notes began to circulate widelythroughout the country and were rarely redeemed.With their convertibility no longer in question,reserve requirements against national bank noteswere lifted in 1873. Requirements remained inplace on deposits, however, which were just emerg-ing as an accepted means of payment. As timewore on, the role of deposits expanded, and theyeventually supplanted bank notes as the preferredmedium of exchange for many transactions, withtheir convertibility supposedly reinforced byreserve requirements.

A series of bank runs and financial panics in thelate nineteenth and early twentieth centuries madeit patently clear that reserve requirements couldnot really guarantee the convertibility of depositsfor the entire banking system. In fact, reserverequirements were really no help at all in providingliquidity during a panic because a given dollar ofreserves could not be used simultaneously to meeta customer’s demand for cash and to satisfy reserverequirements. What was lacking from the nationalbanking system or, for that matter, from any frac-tional reserve system—one with reserve require-ments of less than 100 percent—was a mechanismfor accommodating temporary variations in thepublic’s demand for liquidity by adjusting thequantity of reserves available to the entire bankingsystem. Absent such a mechanism, systemic panicsand crises stemming from fluctuating liquidityneeds were all too common. Though an individualbank might be able to meet a temporary surge inthe demand for cash with little attendant adverse

effect on the economy, the banking system as awhole could not without selling securities or call-ing in loans, thereby squeezing credit supplies,driving up interest rates, and precipitating a generalfinancial crisis.

Creation of the Federal Reserve System

The Federal Reserve Act of 1913 created a systemof Reserve Banks that could act as lenders of lastresort by accommodating the temporary liquidityneeds of the banking system and thereby alleviat-ing the periodic financial disruptions that plaguedthe national bank era. By discounting eligible assetsof member banks, Federal Reserve Banks provideda ready, accessible source of liquidity that had beenmissing from the national banking system.

Although the creation of the Federal ReserveSystem seemingly eliminated any remaining liquid-ity rationale for reserve requirements, banks thatwere members of the System were still required tohold reserves, though requirements were lower thanthose previously in effect for most national banks.In the original Federal Reserve Act, banks hadto hold in reserve different percentages of theirdemand deposits—deposits that could be with-drawn on demand—depending on whether theywere classified as central reserve city banks(18 percent), reserve city banks (15 percent), orcountry banks (12 percent).5 In addition, all mem-ber banks faced a 5 percent requirement on timedeposits.6 Member banks outside central reservecities were not allowed, however, to meet part oftheir requirements with interest-bearing balances ata bank in a central reserve city. Starting in 1917,moreover, member banks could no longer use vaultcash to satisfy reserve requirements: They had to

5. Originally, the rationale for these distinctions among citieswas a carryover from the designation of redemption cities in thenational bank era. In 1913, banks in New York, Chicago, andSt. Louis were classified as central reserve city banks, and banks inabout fifty other cities were designated as reserve city banks. In1922, St. Louis was reclassified as a reserve city, and in 1962 thecentral reserve city designation was eliminated altogether. Over theyears, the number of reserve cities changed somewhat as somecities were added and others deleted by the Federal Reserve Board.

6. For details on the history of changes in reserve requirementssince the inception of the Federal Reserve, see the appendix.




meet their requirements entirely with non-interest-bearing balances at a Federal Reserve Bank.

On net, therefore, the effective burden of reserverequirements in terms of forgone interest wassomewhat higher for member banks than for non-member banks, particularly for those outside cen-tral reserve cities. To help offset this increasedburden, in 1917 reserve requirements on demanddeposits were pared further, to 13 percent, 10 per-cent, and 7 percent respectively for the three typesof member banks, and requirements on time depos-its were reduced from 5 percent to 3 percent for allmembers. These reductions, coupled with the bene-fits of access to Federal Reserve credit at the dis-count window and free Federal Reserve services—such as check clearing and currency distribution—were considered sufficient encouragement forbanks to become members of the System, despitethe higher reserve requirement burden that suchmembership often entailed. In later years, however,the burden of reserve requirements would becomemore acute, making membership less desirable formany institutions.

Reserve Requirements as a Means ofInfluencing Credit Conditions

In the 1920s and 1930s, the Federal Reserve gradu-ally began to expand its original, reactive role aslender of last resort and guarantor of the liquidityof the banking system and adopted a more proac-tive posture in attempting to influence the nation’scredit conditions. As the emphasis of monetarypolicy evolved, so too did the rationale for reserverequirements. In fact, by 1931, the Federal Reservehad officially abandoned the view that reserveswere a necessary or useful source of liquidity fordeposits, arguing instead that reserve requirementsprovided a means for influencing the expansion ofbank credit.7 Specifically, the Federal Reservebelieved that requiring banks to hold reservesagainst the additional deposits needed to fund eachincrement of new loans could help restrain anoverly rapid expansion of credit.

In practice, however, reserve requirements wereof little help in containing the rapid credit growththat occurred in the late 1920s. During this period,the primary tool used by the Federal Reserve toinfluence credit conditions was the discount rate.Because this rate was generally kept below marketrates and only marginal administrative pressurewas used to dissuade banks from availing them-selves of the discount window, banks had an incen-tive to borrow the reserves they needed to financetheir rapidly expanding assets from the FederalReserve, and they responded vigorously to thisincentive. Throughout much of the 1920s, discountwindow borrowings were more than half of totalFederal Reserve assets. With the Federal Reserveeffectively accommodating much of the increasedcredit expansion, reserve requirements placed nosignificant constraint on lending. In addition, theFederal Reserve had no authority to raise reserverequirements even if it had wanted to make them amore binding constraint on credit expansion.

During the Great Depression, as market interestrates plunged and loan demand all but dried up,reserve requirements were obviously not needed tocurtail credit growth. In fact, through much of thisperiod, banks held large quantities of reserves inexcess of their reserve requirements, suggestingthat reserve requirements were not in any wayconstraining credit expansion. The Federal Reservewas concerned that these large excess reservescould eventually be used to support an overly rapidbuildup of deposits and loans that could ultimatelyprove inflationary. Therefore, it excercised itsnewly acquired powers under the Banking Act of1935 and doubled the required reserve ratios onboth demand and time deposits, thereby effectivelyabsorbing much of extant excess reserves.8 By1938, however, as evidence mounted that thenascent economic recovery was imperiled, the Fed-eral Reserve moved to trim reserve requirementson both demand and time deposits, hoping to freeup additional funds for lending.

7. See ‘‘ Member Bank Reserves—Report of the Committee onBank Reserves of the Federal Reserve System,’’ in Board of Gover-nors of the Federal Reserve System, 19th Annual Report, 1932(Board of Governors, 1933), pp. 260–85.

8. The Thomas Amendment of 1933 first granted authority tothe Federal Reserve Board to raise reserve requirements, subject topresidential approval, provided that a national emergency wasdeclared. The Banking Act of 1935 eliminated the need for presi-dential approval or the declaration of an emergency, though it alsoprecluded the Board from reducing requirements below the levelsthen in force or from more than doubling those requirements.




In the years surrounding World War II, monetarypolicy considerations became subordinate tofinancing the government debt. During this period,the Federal Reserve abandoned an active monetarypolicy role and chose as its highest priority toaccommodate the government’s financing needs bybuying Treasury securities at low interest rates.

Postwar Issues: Membership Attrition andMonetary Control

In 1951, the Federal Reserve resumed an active,independent monetary policy. In subsequent years,reserve requirements were adjusted numeroustimes, usually to reinforce or supplement the effectsof open market operations and discount policyon overall monetary and credit conditions. In theshort run, however, reserve requirements placedlittle constraint on the expansion of depositsbecause the Federal Reserve largely accom-modated any such expansion through open marketoperations. Over time, though, if the FederalReserve sought to reduce the availability of moneyand credit by providing reserves less generouslythrough open market operations, it could andoften did augment its actions by raising reserverequirements.

The use of reserve requirements as a supplemen-tal tool of monetary policy was particularly preva-lent in the 1960s and 1970s, as the Federal Reservesought to influence the expansion of money andcredit in part by manipulating bank funding costs.As financial innovation spawned new sources ofbank funding, the Federal Reserve began to adaptreserve requirements to these new financial prod-ucts and often changed requirements on the specificbank liabilities that were most frequently usedas marginal sources of funding. As banks beganto rely more heavily on the issuance of large-denomination time deposits (CDs) to fund theirasset acquisitions in the 1960s, for example, theFederal Reserve began periodically to alter reserverequirements on these instruments, thereby affect-ing their cost of issuance and, thus, the supply ofcredit through banks. It sometimes supplementedits actions by placing a marginal reserve require-ment on large time deposits—that is, an additionalrequirement applied only to each new increment ofthese deposits.

Reserve requirements were also imposed onother, newly emerging liabilities that were the func-tional equivalents of deposits. For example, asbanks started to rely more on Eurodollar borrow-ings as a funding source in the late 1960s, partly inan effort to circumvent existing reserve require-ments, the Federal Reserve imposed marginalrequirements on these liabilities and adjusted theserequirements periodically throughout the 1970s.The imposition of reserve requirements on theseand other managed liabilities was especially usefulin the late 1970s, as the Federal Reserve aggres-sively sought to curb the expansion of money andcredit and thereby ease price pressures.

Throughout this period, reserve requirementsalso had important implications for membership inthe Federal Reserve System. Since membershipwas optional for state-chartered banks, some ofthese institutions began to leave the System in the1950s to take advantage of the lower reserverequirements imposed by most state regulatoryauthorities, some of whom also allowed banks tomeet part of their requirements with interest-earning assets. The Federal Reserve feared that ifenough banks left the System, changes in the costand availability of reserves to the remaining mem-ber banks might have a diminished effect on over-all monetary and credit conditions, thus undermin-ing the efficacy of monetary policy.

Change in vault cash accounting. To reduce theburden of reserve requirements and stem the ero-sion of membership in the System, legislation wasenacted allowing banks to resume using vault cashto satisfy their reserve requirements. This change,which was phased in beginning December 1959,provided the greatest relief to small banks, whichtended to hold relatively large quantities of vaultcash to meet their customers’ liquidity needs. Per-mitting this vault cash to be used to meet reserverequirements reduced the amount of non-interest-bearing balances these banks had to hold at theFederal Reserve. Because smaller banks were mostapt to leave the System, it was hoped that thisreform would help stanch membership attrition.Although larger banks tended to benefit less fromthis rule change, they were less likely to leave theSystem because they often reaped the greatestbenefits from free Federal Reserve services, par-




ticularly those related to the clearing of financialtransactions.

The change in vault cash accounting did in factreduce the level of required reserve balances some-what in the early 1960s (top panel of chart 1). Thisdecline, coupled with a drop in short-term interestrates (middle panel of chart 1), helped lighten theburden of reserve requirements in terms of theinterest forgone on required reserve balances (bot-tom panel of chart 1).

Proposals to change the structure of reserverequirements. This relief proved temporary, how-ever. As interest rates climbed in the late 1960s andinto the 1970s, the burden of reserve requirements

became more onerous; with higher interest rates,banks were being forced to forgo more earnings byholding non-interest-bearing required reserve bal-ances. Indeed, the marginal tax rate on transaction(demand) deposits—the reserve tax on an addi-tional dollar of these deposits, as measured by thereserve requirement times the rate of interestforgone—rose through much of this period as well(chart 2). As a result, more banks began to leavethe Federal Reserve System, taking with them anever-increasing share of the deposits in the bankingsystem. By the early 1970s, for example, the shareof transaction deposits held by member banks hadfallen below 75 percent from nearly 85 percent inthe late 1950s (chart 3). In response, the FederalReserve began to argue for additional legislationaimed at stemming the corrosive effects of thedecline in membership on monetary control. Eitherall depository institutions should be subject toreserve requirements established by the FederalReserve, thereby rendering the membership issueirrelevant, the System argued, or interest should bepaid on required reserve balances, thereby remov-ing banks’ primary motive for leaving the System.9

Opposition to both proposals proved strong,however, with nonmember banks leading the cru-sade against universal reserve requirements and

9. Each Annual Report of the Board of Governors of the FederalReserve System between the years 1964 and 1979 argued for theadoption of legislation aimed at reforming the structure of reserverequirements to combat the problem of membership attrition.

1. Burden of reserve requirements, 1959–92¹

Required reserve balances

Forgone interest(Actual dollars)2

20

40

60

Billions of dollars

Required reservesAppliedvault cash

5

10

15

Percentage points

Effective federal funds rate

2

4

6

Billions of dollars

1960 1965 1970 1975 1980 1985 1990

Forgone interest(1982 dollars)2

1. Data are annual averages. 2. Forgone interest is defined as required reserve balances multiplied by

the federal funds rate.

2. Marginal reserve tax on transaction deposits, 1959–93:Q1¹

5

10

15

20

25

Basis points

1960 1965 1970 1975 1980 1985 1990

1. The marginal reserve tax is the quarterly average effective federalfunds rate times the highest reserve requirement on transaction depositsduring the quarter.




with both the legislative and executive branches ofthe federal government opposed to interest onreserves out of concern about Treasury revenues.In fact, a 1963 presidential commission cautionedagainst any significant cuts in reserve requirementsto avoid a sharp drop in Treasury revenue.10 Mostacademics, by contrast, usually supported retainingand even increasing reserve requirements to tightenthe link between reserves and money, while payinginterest on reserves to eliminate the distortionaleffects of the reserve tax.11

Lagged reserve requirements. Thwarted in itsattempts to promote substantive change in thestructure of reserve requirements, the FederalReserve took several smaller, unilateral steps aimedat stemming membership attrition. In 1968, a sys-tem of lagged reserve requirements (LRR) wasimplemented in which a bank’s required reserveswere computed based on its deposit levels fromtwo weeks earlier. Previously, the computationperiod for deposits had been essentially contempo-raneous with the maintenance period for reserves.By switching to LRR, the Federal Reserve hoped tomake it less difficult and costly for banks to calcu-late their reserve requirements and to manage their

reserve positions. One problem with LRR was thatit weakened the direct, contemporaneous linkbetween reserves and money, thus making it harder,in principle, to manipulate reserves to controlmoney, at least in the short run. This problem wasnot considered a serious one, however, becauseFederal Reserve procedures at that time were notdirected at tight, short-run control of moneythrough a reserves operating target.

Graduated reserve requirements. In the late1960s, the Federal Reserve also began to moveaway from a system of reserve requirements basedon geographic distinctions, as embodied in thereserve city bank and country bank designations.By 1972, the old system was eliminated altogether,and a new system with a progressive, graduatedreserve requirement schedule was implemented.Under the new system, reserve requirementsincreased with the level of each bank’s deposits,independent of its location. Although the specificswere somewhat complicated (see the appendix fordetails), the upshot of the change was to reducereserve requirements for smaller banks, which werestill most likely to leave the System. At the sametime, however, the move to a system with manyreserve requirements based on different depositlevels further weakened the link between the aggre-gate level of reserves and the total amount ofdeposits in the banking system. Again, however,because the Federal Reserve was not trying tomaintain control of deposits through a reserves-targeting procedure, this effect was not a majorconcern.

Continued decline of membership. Despite theefforts of the Federal Reserve, the decline of mem-bership in the System continued unabated, with theproportion of transaction deposits at member banksfalling below 65 percent of total transaction depos-its by the late 1970s (chart 3), in part because risinginterest rates were enlarging the reserve tax(charts 1 and 2). In response, the Federal Reservebegan to argue more vociferously for changes inthe structure of reserve requirements to preventmembership attrition from further undermining theefficacy of monetary policy.12 In 1978, it even went

10. Report of the Committee on Financial Institutions to thePresident of the United States, Walter W. Heller, Chairman(GPO, 1963).

11. See, for example, Milton Friedman, A Program forMonetary Stability (Fordham University Press, 1959),pp. 65–76; Thomas Mayer, ‘‘ Interest Payments on RequiredReserve Balances,’’ Journal of Finance, vol. 21 (March 1966),pp. 116–18; and George S. Tolley, ‘‘ Providing for Growth of theMoney Supply,’’ Journal of Political Economy, vol. 65 (December1957), pp. 477–85.

12. See ‘‘ Statement by G. William Miller, Chairman, Board ofGovernors of the Federal Reserve System, before the Committee

3. Member bank transaction deposits as a share of total transaction deposits, 1959–80¹

65

70

75

80

85

Percent

19801975197019651960

1. Transaction deposits are defined as net demand deposits plus NOWaccounts. Data are expressed as annual averages.




so far as to propose a unilateral plan to pay intereston reserves, which elicited strenuous congressionalopposition.13

The relative decline in the deposit base at mem-ber banks became particularly worrisome afterOctober 1979, when the Federal Reserve adopted areserves-based operating procedure designed tomaintain close, short-run control of Ml. The suc-cess of this procedure depended in part on howtight the link was between reserves at memberbanks and the level of M1 deposits in the entirebanking system—a link that was being weakenedby the continued decline in membership as wellas by some of the steps the Federal Reserve hadtaken to try to reverse this decline, includingswitching to LRR and instituting graduated reserverequirements.

The Monetary Control Act and M1 Targeting

After years of debate, the Congress finally adoptedlegislation to reform reserve requirement rules inorder to end the problem of membership attritionand facilitate control of Ml. The Monetary ControlAct of 1980 (MCA) mandated universal reserverequirements to be set by the Federal Reserve forall depository institutions, regardless of their mem-bership status. The act also vastly simplified thegraduated reserve requirement schedule, furthertightening the link between reserves and money.Although the key focus was on transaction (M1)deposits, all of which were made subject to reserverequirements, certain types of nontransactiondeposits also became subject to requirements,which effectively broadened the reserve base andrequired more depositories to hold reserve bal-ances. In this way, the Federal Reserve’s ability toinfluence aggregate deposit levels by manipulatingthe quantity of reserves was improved. The MCA

also granted the Federal Reserve authority toimpose a supplemental reserve requirement of upto 4 percent on transaction accounts. Finally, as aresult of MCA, the number of depositories requiredto report their deposits to the Federal Reserveincreased markedly, thus improving the accuracyand timeliness of data necessary for monetarycontrol.

To ease the burden of reserve requirements, theMCA initially set the basic reserve requirement ontransaction deposits at 12 percent—below the161⁄4 percent maximum that had been in effectfor member banks—and prohibited the FederalReserve from raising this requirement above14 percent. It also set a 3 percent reserve require-ment on the first $25 million of deposits at eachinstitution—the so-called low reserve tranche—asa special concession to smaller depositories.

In 1982, the Garn–St Germain Act went evenfurther by exempting from reserve requirementsaltogether the first $2 million of deposits. The lawmandated annual adjustments to the cutoffs for theexemption and the low reserve tranche based onaggregate growth in reservable liabilities and trans-action deposits respectively. To help smooth thetransition for nonmember banks and thrift institu-tions, a multiyear phase-in period was put in place,and the Federal Reserve was also prohibited fromputting reserve requirements on personal time andsavings deposits, which were particularly impor-tant sources of funds for these institutions. Finally,all institutions with reservable deposits, not justmember banks, now had access to the discountwindow as well as to Federal Reserve services,including check clearing, funds transfers, and thelike, though these services were no longer to beprovided free of charge.

The MCA did not specifically prohibit or autho-rize the payment of interest on required reserves,although it mandated the payment of interest onsupplemental reserves should the Federal Reserveever impose them. The legislative history of theMCA indicates that the Congress was concernedabout the possible adverse effects of the act onTreasury revenues, so much so that the MCA evenprohibits the Federal Reserve from lowering thereserve requirement to less than 8 percent on trans-action deposits. The legislative history also indi-cates that the Congress was concerned that pay-ment of interest on reserves would give the Federal

on Banking, Finance and Urban Affairs, U.S. House of Representa-tives, July 27, 1978,’’ Federal Reserve Bulletin, vol. 64 (August1978), pp. 636–42; and ‘‘ Statement by Paul A. Volcker, Chairman,Board of Governors of the Federal Reserve System, before theCommittee on Banking, Housing, and Urban Affairs, U.S. Senate,February 4, 1980,’’ Federal Reserve Bulletin, vol. 66 (February1980), pp. 643–48.

13. For details on the Federal Reserve’s proposal, see FederalReserve Bulletin, vol. 64 (July 1978), pp. 605–10. For congres-sional reaction, see ‘‘ Monetary Control and the MembershipProblem.’’ Hearings.




Reserve, in its role as a provider of financial ser-vices, an unfair competitive advantage over deposi-tory institutions, which are prohibited from payinginterest on demand deposits. Appreciative of thisconcern and aware of the distortions created by theprohibition of interest payments on demand depos-its, the Federal Reserve advocated removal of thisprohibition in conjunction with the payment of in-terest on reserves.14 Neither proposal was adopted,however. Thus, the reserve tax on depositories andtheir customers remained.

In 1982, the Federal Reserve took another step toimprove its short-run control of M1 by deciding toswitch to a contemporaneous reserve requirement(CRR) scheme. By making the period in whichbanks are required to maintain their reservesagainst transaction deposits virtually contempora-neous with the period in which deposit levels arecomputed for the purpose of determining reserverequirements, this move tightened the real-timelink between reserves and M1.15 In so doing, itremedied a weakness in the short-run monetarycontrol mechanism of the existing, reserves-basedoperating procedure.

Reserve Requirements since the Abandonmentof MI Targeting

Ironically, by the time CRR was instituted in 1984,the Federal Reserve had shifted its focus awayfrom short-run control of M1 via a reserves-basedoperating procedure, preferring instead to influencemonetary and credit conditions by adjusting thecost and availability of reserves to depositories. Italso shifted its focus more toward M2, as thisaggregate was seen as more closely linked to theultimate objectives of monetary policy than M1,which had become overly sensitive to interest ratesafter the authorization of nationwide NOWaccounts and the general deregulation of depositrates. Thus, the basic structure of reserve require-ments, which had been meticulously designed to

facilitate the control of M1 through a reserves-oriented targeting procedure, had seeminglybecome an anachronism.

In fact, however, reserve requirements continuedto play an important role in the conduct of mone-tary policy, in part by providing a stable, predict-able demand for aggregate reserves. Absent reserverequirements, banks would still hold some balancesat the Federal Reserve to meet their clearing needs.Given the size and volatility of the financial trans-actions that clear through these reserve accounts,depositories need to maintain a cushion of balancesin these accounts to provide some protectionagainst uncertain debits that can potentially leavetheir accounts overdrawn at the end of the day andsubject to stiff penalties.16 The exact amount ofbalances that banks wish to hold for clearing pur-poses may vary considerably from day to day,however, and cannot be forecast with much preci-sion by the Federal Reserve. By making reserverequirements the binding constraint on banks’demand for reserves—that is, by keeping requiredreserve balances above the uncertain level neededfor clearing purposes—the Federal Reserve canmore accurately determine the banking system’sdemand for reserves. In this way, it can morereadily achieve any desired degree of pressure onbank reserve positions and associated reservemarket conditions simply by manipulating themaintenance-period-average supply of reserves.

By requiring banks to hold an average amount ofreserves over a two-week maintenance periodrather than a specific amount on each day, currentregulations allow considerable flexibility in dailyreserve management. Banks can use this flexibilityto arbitrage anticipated, intraperiod variations inthe cost of reserves (the federal funds rate), bysubstituting reserves on one day of the period whenthey are expected to be less costly for reserves onanother day when they are expected to be morecostly. This sort of intraperiod arbitrage serves toreduce day-to-day fluctuations in the cost ofreserves. The lower the level of required reservebalances, however, the less leeway a bank has formanipulating the intraperiod profile of its reserve

14. See statement by J. Charles Partee, October 27, 1983.15. Actually, banks were required to hold an average amount of

reserves over a two-week maintenance period ending every otherWednesday, based on average deposit levels in a two-week compu-tation period that ends on a Monday two days before the end of themaintenance period.

16. At present, the penalty rate on overnight overdrafts is thehigher of 200 basis points above the federal funds rate on the day,or 10 percent. In addition, banks have to offset overdrafts later inthe period to meet their reserve requirements.




position without jeopardizing its overnight over-draft protection; hence, the bank will be less able toarbitrage day-to-day variations in the federal fundsrate.

Banks that find their required reserve balancesinsufficient to meet their clearing needs—that is, toprovide them with adequate overdraft protection—are able, under the provisions of MCA, to openclearing balances. Banks can contract with the Fed-eral Reserve to hold an average amount of thesebalances in their reserve accounts over the two-week reserve maintenance period. If they fail tohold the amount required under the contract, theyare penalized, much as would be the case if theyfailed to hold sufficient balances to meet theirreserve requirements. Unlike required reserve bal-ances, however, which do not earn interest, banksreceive earnings credits on the amount of clearingbalances they are required to hold under their con-tractual agreement. They can, in turn, use theseearnings credits to defray the costs of FederalReserve priced services. Thus, from a bank’s per-spective, opening a clearing balance is a virtuallycostless way to boost the average balance it isrequired to hold in its reserve account over the

maintenance period and hence to provide extrainsurance against overdrafts and added flexibilityto reserve management.

Not surprisingly, in the years immediately afterpassage of MCA, as required reserve balances fellas a result of the phased reductions in reserverequirements for member banks (top panel ofchart 4), many of these institutions opened clearingbalances to help replenish their diminished protec-tion against overdrafts. Indeed, by 1986, the bank-ing system as a whole had contracted to holdroughly $13⁄4 billion of clearing balances (bottompanel of chart 4). To a lesser extent, other banks,particularly those using small amounts of pricedservices from the Federal Reserve and those new tomanaging reserve accounts, increased their hold-ings of excess reserves to help meet their clearingneeds. These changes, coupled with a rebound inrequired reserve balances, provided banks withmore of a cushion to handle a sharp increase in thevolume of funds transactions clearing through theirreserve accounts (chart 5).

RECENT CUTS IN RESERVE REQUIREMENTS

In the decade after passage of the MCA in 1980,the Federal Reserve left reserve requirementsessentially unchanged. More recently, however, ithas taken two steps to reduce these requirements.In December 1990, the required reserve ratio onnontransaction accounts—nonpersonal time andsavings deposits and net Eurocurrency liabilities—was pared from 3 percent to zero, and in April

4. Reserve and clearing balances, 1980–89

Excess reserves

20

25

30

35

Billions of dollars

199019881986198419821980

Required reserve balances

.3

.6

.9

1.2

1.5

1.8

Billions of dollars

1980 1982 1984 1986 1988

Required clearing balances

Data are annual averages.

5. Volume of funds transactions clearing through reserve accounts, 1980–90

200

400

600

800

Billions of dollars

199019881986198419821980

Observations are annual averages of daily data.




1992, the 12 percent requirement on transactiondeposits was trimmed to 10 percent.

Rationale

These actions were motivated in part by develop-ments in credit markets, where evidence hademerged suggesting that some lenders had adopteda more cautious approach to extending credit. Thiscaution was exerting a restraining effect on the costand availability of credit to some types of borrow-ers. By reducing depository funding costs and thusproviding depositories with easier access to capitalmarkets, the cuts in reserve requirements weredesigned to put banks in a better position to extendcredit. In particular, the cut in the requirement onnonpersonal time deposits was aimed directly atspurring bank lending because these accounts areoften used as a marginal funding source. Of course,it was recognized that some, if not all, of thebenefits stemming from the reserve requirementcuts would likely be passed on, over time, to bor-rowers and lenders.17

The cuts in reserve requirements were also moti-vated by the Federal Reserve’s recognition thatmuch of the early-1980s rationale for reserverequirements had evaporated with the abandon-ment of a reserves-oriented operating proceduregeared to short-run control of M1. At the sametime, it realized that reserve requirements stillplayed a vital role in policy implementation.Indeed, it chose not to make even deeper cuts inrequirements for fear that required balances wouldfall to levels insufficient to satisfy the normal clear-ing needs of the banking system.

Effects of Reserve Requirement Cuts on theSize of the Reserve Tax

The elimination of the 3 percent reserve require-ment on nontransaction accounts at the end of 1990reduced the level of required reserve balancesroughly $111⁄2 billion, or about one-third (table 2).

Using the 7 percent federal funds rate that pre-vailed at the time as a proxy for the interest thatcould have been earned on these balances, the cutin reserve requirements translated into an increaseof about $800 million in the annual, pretax earn-ings of depositories and their customers.

As a result of this cut in reserve requirements,about 2,500 depositories whose vault cash hadformerly been insufficient to meet their reserverequirements were no longer bound to hold bal-ances at the Federal Reserve. For these institutions,therefore, the reduction in the nontransactionrequirement essentially eliminated the reserve tax.Trimming the required reserve ratio on transactionaccounts in April 1992 relieved several hundredadditional institutions from having to hold balancesat the Federal Reserve. Overall, this second cut inreserve requirements reduced the required reservebalances of the entire banking system about$81⁄2 billion, resulting in annual pretax savings ofroughly $350 million for the private sector, giventhe 4 percent federal funds rate that prevailed at thetime.

Effects on Bank Reserve Managementand Open Market Operations

In the immediate aftermath of the December 1990cut in reserve requirements, the level of requiredoperating balances—the sum of required reservebalances and the amount of clearing balances re-quired to be held under contractual arrangementsbetween depositories and the Federal Reserve—plunged (chart 6). By early February 1991, thesebalances reached a trough of about $181⁄4 billion—barely more than half their level in the periodpreceding the cut in requirements and nearly40 percent below their seasonal low in early Febru-ary 1990. Required operating balances typicallyreach a low point at this time of the year because

17. For details on the rationales for the recent cuts in reserverequirements, see Federal Reserve Bulletin, vol. 77 (February1991), pp. 95–96; and Federal Reserve Bulletin, vol. 78 (April1992), pp. 272–73.

2. Effect of recent cuts in reserve requirements

Effectivedate of

cut

Reduction inrequired reserve

balances(billions of

dollars)

Federalfundsrate

(percent)

Reduction ininterestforgone

(millions ofdollars)

December 1990 . . . . . . 111⁄2 7.0 800April 1992 . . . . . . . . . . 81⁄2 4.0 350




required reserves fall from their end-of-year peak.Also, owing to regulations stipulating that deposi-tories apply their vault cash holdings from twomaintenance periods earlier in meeting their cur-rent reserve requirements, the enlarged holdings ofvault cash from year-end do not become availablefor use in meeting reserve requirements until lateJanuary and early February.

With required operating balances falling belowthe levels needed by many depositories for dailyclearing purposes, the marginal dollar of reservedemand often stemmed from clearing needs on theday, rather than from a reserve requirement aver-aged over two weeks. As a result, banks had lessscope for manipulating their reserve positions fromone day to the next and, consequently, for arbitrag-ing anticipated intraperiod variations in the cost ofreserves. Not surprisingly, a variety of measures offederal funds rate volatility posted significantincreases (chart 7). At the same time, many deposi-tories held levels of excess reserves that greatlyexceeded those seen in comparable periods ofrecent years in order to restock their depleted over-draft protection (chart 8). Because the extent towhich banks wanted to boost their holdings ofexcess reserves was unknown to the FederalReserve, it became more difficult to estimate thedemand for reserves and, thus, to conduct openmarket operations.

Transition to a More Orderly Reserve Market

Over the next few months, reserve market condi-tions returned to normal, with both excess reservesand the volatility of the funds rate falling backmore or less to levels seen before the cut in reserverequirements. Although the reasons for the morestable reserve market climate varied, the rapidrebuilding of required operating balances was prob-ably the most important. The higher level of bal-ances provided banks with more adequate overdraftprotection and greater flexibility in managing theirreserve positions, thus reducing the need for excess

7. Reserve market volatility, 1988–March 31, 1993

1

1030

Percent (ratio scale)

Variance of daily effective federal funds rate1

Reserverequirement cut


20

40

60

80

100

120funds rate from the maintenance period average

Basis points

199319921991199019891988

Mean absolute deviation of daily effective federal



1. Computed around the maintenance period average.

6. Reserve balances, 1989–March 31, 1993

Requiredoperatingbalances2

20

25

30

35

40

45

Billions of dollars

19931992199119901989

Maintenance period averages1



Requiredreserve balances

1. Reserve maintenance periods run for two weeks, so that there aretwenty-six periods each year. In this chart and in charts 7, 8 ,and 9, thereare twenty-six observations for each full year.

2. Required operating balances are required reserve balances plusrequired clearing balances.

8. Excess reserves, 1989–March 31, 1993

1

2

3

4

5

Billions of dollars

19931992199119901989

Maintenance period averagesReserverequirement cut





balances and providing additional leeway for arbi-trage in the funds market.

The pronounced rebound in required operatingbalances over the remainder of 1991 owed in partto a surge in required reserves stemming fromrapid growth in transaction deposits. Furthermore,deliberate efforts by depositories to hold additionalbalances also played a role in the faster-than-usualincrease in required operating balances. For exam-ple, banks used clearing balances much more afterthe cut in reserve requirements (chart 9). Evidencealso suggests that some banks sought to economizeon their vault cash holdings to boost their requiredreserve balances. In addition, depositories mayhave learned to manage their reserve accounts moreefficiently, making use of improved, real-timeinformation on the status of their reserve balancesthroughout the day to lower the cushion theyneeded to hold as insurance against uncertain debitsthat can result in overdrafts.

The Cut in the Transaction Requirement

With the reserve market functioning reasonablywell again, the Federal Reserve believed that itcould safely lower reserve requirements once more.As it turned out, the cut in the transaction require-ment in April 1992 was relatively uneventful.Although required operating balances initiallydropped sharply, the decline was not nearly asprecipitous as that seen in early 1991; not only wasthis cut smaller in terms of its effect on requiredreserve balances, it also came at a time of the yearwhen these balances tend to be high because of thebuildup of transaction deposits in anticipation ofthe April 15 tax date. Moreover, required operating

balances quickly made up all their lost ground,spurred by continued rapid growth in requiredreserves and another surge in the use of clearingbalances. Indeed, these balances now total about$6 billion, or more than three times their levelbefore the first cut in reserve requirements; theynow make up nearly 20 percent of required operat-ing balances versus about 5 percent in late 1990.

The Federal Reserve also made several changesin reserve accounting rules to help banks bettermanage their accounts in a world of lower require-ments and to aid the implementation of monetarypolicy. First, to smooth the seasonal pattern inrequired operating balances, the Federal Reservereduced the lag on the application of vault cash foruse in meeting reserve requirements from twomaintenance periods to one, effective in the periodbeginning November 12, 1992. By more closelysynchronizing the movements in required reservesand applied vault cash, this change was designed totemper seasonal declines in required operating bal-ances, particularly the most severe decline, whichoccurs in late January and early February. To givedepositories greater flexibility in managing theirreserve positions from one period to the next, theFederal Reserve also doubled the carryover privi-lege, which enables banks to carry forward into thenext maintenance period small reserve surplusesand deficiencies.18

These changes, coupled with the rebound inrequired operating balances, helped prevent the cutin the transaction requirement from having adverseeffects on the functioning of the reserve market oron the conduct of open market operations. In fact,most measures of the volatility of the federal fundsrate are up only marginally relative to their levelsbefore December 1990, and aggregate excessreserves are running only a shade higher thanbefore the cuts in reserve requirements. Some evi-dence suggests, however, that banks do have a bitless flexibility in managing their reserve positionsfrom day to day; in particular, some systematicpatterns in the behavior of the federal funds ratewithin reserve maintenance periods have intensi-fied, suggesting that banks may not have as much

18. Since September 1992, depositories have been able to carryforward one maintenance period the greater of 4 percent of requiredreserve plus clearing balances, or $50,000; the carryover allowancehad previously been the greater of 2 percent, or $25,000.

9. Required clearing balances, 1989–March 31, 1993

2

4

6

8

Billions of dollars

19931992199119901989

Maintenance period averages






scope to arbitrage in the funds market as they oncedid.19

Concerned that additional declines in requiredoperating balances would complicate reserve man-agement and the conduct of open market opera-tions, the Federal Reserve has not made furthercuts in reserve requirements. Nevertheless, owingto the cuts it did make as well as to declines inshort-term interest rates, the reserve tax has beenfalling sharply in recent years (chart 1). Conse-quently, the marginal tax rate on transaction depos-its has dipped to its lowest level in thirty years(chart 2). Even so, this tax still represents a burdenon the private sector, and one that could rise signifi-cantly if interest rates were to increase. Cognizantof the actual and prospective burden of the reservetax, depositories continue to work to fashion finan-cial products aimed largely at exploiting loopholesin reserve regulations.

POTENTIAL REFORMS TO THECURRENT SYSTEM

Several suggestions have been put forth over theyears for reforming the system of reserve require-ments. In this section, I review some of theseproposals, drawing heavily on the lessons learnedfrom the recent cuts in reserve requirements as wellas from the experiences of other countries that havelowered reserve requirements in recent years.

Eliminate Reserve Requirements

Although this proposal would clearly eliminate thereserve tax, recent experience suggests that itwould also engender a significant increase in vola-tility in the reserves market and seriously compli-cate the conduct of open market operations. More-over, absent reserve requirements, the FederalReserve would be unable to reinstitute an effective,

reserves-oriented targeting procedure to controlmoney growth if it ever deemed this actionappropriate.

Recent Trends in Other Countries

Several other countries have significantly reduced,and in some cases essentially eliminated, reserverequirements in recent years. In the United King-dom and Switzerland, for example, reserve require-ments no longer effectively constrain bank behav-ior. In these countries, most banks find that theirrequired reserves fall short of their daily clearingneeds, so that at the margin the latter essentiallydetermine their demand for reserves. More recently,Canada has also begun to phase out reserverequirements, and by 1994, their requirements willbe completely eliminated.

These countries have taken different steps, basedon their own unique institutional structures, tofacilitate bank reserve management and the con-duct of open market operations in a world of non-binding reserve requirements. The Bank of England(BOE), for example, has adopted a more flexibleoperating procedure, often intervening in themoney markets several times a day to fine tune thecost and availability of reserves to meet ever-changing clearing needs. In addition, banks in theUnited Kingdom are usually willing to borrowfrom the BOE late in the day to meet their clearingneeds. Banks in the United States, by contrast, havebecome increasingly reluctant in recent years toavail themselves of Federal Reserve discount win-dow credit, in part out of concerns that doing somight be interpreted by market participants as asign of financial weakness. Even so, the volatilityof overnight interest rates in the United Kingdomhas tended, on average, to be somewhat higher thanthat in the United States, where reserve require-ments are still binding for many institutions.

The Swiss National Bank (SNB) has adopted adifferent approach than the BOE. Although it nowplaces somewhat greater emphasis on smoothingshort-term interest rates than it did in the past, ithas been much less accommodative in offsettingtemporary fluctuations in clearing needs than hasthe BOE. As a result, Switzerland has experiencedgreater volatility in overnight rates than the UnitedKingdom, and Swiss banks have chosen to holdsubstantial excess reserves, in part because over-

19. Specifically, the federal funds rate has tended to be lower onFridays, when reserves count three times in the calculation of abank’s period-average position; depositories are apparently morereluctant to build up their reserve balances on these days for fearthat they will be unable to work them off later in the period withoutjeopardizing their overdraft protection. On settlement days, bycontrast, the funds rate has tended to be higher, as banks movemore aggressively to meet their reserve requirements. The persis-tence of systematic, intraperiod patterns in the funds rate suggeststhat arbitrage opportunities are not being fully exploited.




night overdrafts are prohibited. At the same time,however, the ability of Swiss banks to access SNBcredit at their own discretion, albeit at a penaltyrate, has likely served to temper reserve marketvolatility somewhat.

Although the jury is still out on the full ramifica-tions of Canada’s elimination of reserve require-ments, which is in the process of being phased in,the Bank of Canada (BOC) feels that its financialsystem is amenable to functioning smoothly in theabsence of reserve requirements. Specifically, Can-ada’s system is highly concentrated, with a handfulof large depositories controlling the lion’s share offinancial assets and handling the vast majority offinancial transactions. These ‘‘ direct clearers’’ willbe required to clear all transactions through reserveaccounts at the BOC, and although they will haveno reserve requirements, they will be penalized iftheir reserve accounts are overdrawn. Thus, ademand for reserve liabilities at the central bankwill be preserved, thereby enabling the BOC toimplement monetary policy by manipulating thesupply of reserves relative to this demand. Becausethe number of direct clearers is so small, moreover,the BOC can readily gauge the demand for clearingbalances simply by keeping in close contact withthe relevant banks. Finally, the BOC is also able toadjust the supply of reserves late in the day bymoving government deposits between accounts incommercial banks and accounts at the BOC,thereby helping to mitigate volatility in the reservesmarket.

Other central banks, such as the Bundesbank andthe Bank of Japan (BOJ), which operate in finan-cial environments more akin to those found in theUnited States, have not eliminated reserve require-ments. Echoing arguments made by the FederalReserve, both the Bundesbank and the BOJ believethat reserve requirements are essential for provid-ing the stable, predictable demand for reserves thatis needed for the conduct of open market opera-tions and the prevention of undesirable money mar-ket volatility. Thus, although the Bundesbank haspared reserve requirements in recent years, theserequirements are still binding for most Germanbanks.

Overall, based on the recent experience in theUnited States and the experiences of other coun-tries, it seems clear that the Federal Reserve wouldhave to alter its other tools of monetary policy

dramatically if it eliminated reserve requirements.In particular, to preserve its ability to conduct openmarket operations, it would have to ensure thatdepositories still had a demand for reserve liabili-ties at the Federal Reserve. To this end, it wouldlikely have to require at least some depositories toclear their financial transactions through the Fed-eral Reserve and to continue to subject them topenalties for overnight overdrafts. At the sametime, it would probably also have to do somethingto make depositories less reluctant to use the dis-count window as a safety valve to defuse reservemarket pressures. Even so, volatility in the moneymarket is likely to rise significantly, and the Fed-eral Reserve’s ability to achieve desired reservemarket conditions might be undermined as a resultof the difficulty in gauging the banking system’sdemand for reserves.

Pay Interest on Required ReserveBalances—the Preferred Solution

Paying interest on reserves is a preferable alterna-tive to eliminating reserve requirements. Specifi-cally, if the Federal Reserve paid a market-basedrate of interest on required reserve balances, thereserve tax would essentially be eliminated, aswould the distortional effects of this tax on resourceallocation. Households and businesses would notface an artificially imposed incentive to redirectcredit flows away from depositories. Furthermore,depositories would no longer have an incentive todevote resources to new methods of reserve avoid-ance. If required reserve balances earned interest,moreover, the Federal Reserve could even raisereserve requirements if it wanted to provide bankswith greater flexibility in managing their reservepositions, reduce volatility in the money markets,and simplify the conduct of open market opera-tions, without having to worry about imposing atax on the private sector.20

20. An alternative proposal would have the Federal Reserveraise reserve requirements and pay interest only on the increasedbalances depositories were required to hold. Though this planwould not reduce Treasury revenue, it would also not do anythingto reduce the deleterious effects of the current reserve tax. Fordetails on this proposal, see Spence Hilton, Melissa Gerdts, andRoxann Robinson, ‘‘ Paying Interest on Reserves,’’ in FederalReserve Bank of New York, Reduced Reserve Requirements: Alter-natives for the Conduct of Monetary Policy and Reserve Manage-ment (New York: FRBNY, 1993).




In the past, proposals to pay interest on requiredreserve balances have encountered resistancelargely because they would reduce the earningsremitted by the Federal Reserve to the Treasury.Required reserve balances have been declining as ashare of total Federal Reserve liabilities for years,however, and now make up only about 7 percent ofthe total (chart 10). As a result of this decline,which owes to reductions in reserve requirementsas well as to relatively rapid growth of currency incirculation, the payment of interest on requiredreserve balances would now engender a relativelysmaller reduction in the amount of Federal Reserveearnings remitted to the Treasury than ever before.In addition, it had often been argued in the pastthat the reserve tax on the depository system and itscustomers was more than offset by the government-backed deposit insurance program, which provideda subsidized, implicit government guarantee thatconferred an advantage on depositories in theircompetition with other financial intermediaries.More recently, however, the price of this govern-ment guarantee has risen substantially. Not onlyhave deposit insurance premiums been raisedsharply, but capital requirements for depositorieshave been increased, more stringent standards forinterbank lending have been imposed, and certainrestrictions on deposit pricing have resurfaced.Taken together, these changes have served toincrease the costs of intermediation through thedepository system. Partly as a result of theseincreased costs, the share of new credit flows inter-mediated through the depository system has fallendramatically in recent years. Although many of thecredits formerly booked by banks and thrift institu-tions have been picked up by other intermediaries

or have been channeled directly through the capitalmarkets, with little attendant effect on the cost oravailability of credit to most borrowers, some cred-its that are less easily substitutable, such as loans tosmall and medium-sized businesses, may have beencurtailed, at least partly as a result of the increasesin depository intermediation costs. Thus, it may bethese borrowers who ultimately pay much of theprice of the higher, government-mandated costs ondepositories. Paying interest on required reservebalances would be one way of offsetting some ofthese higher costs.

APPENDIX: SUMMARY OF RESERVEREQUIREMENTS SINCE 1913

The tables in this appendix summarize changes inrequired reserve ratios since the inception of theFederal Reserve System in 1913.

Three major structures of reserve requirementshave been used since 1913. The first two, whichpreceded passage of the Monetary Control Act of1980, applied reserve requirements only to banksthat were members of the Federal Reserve System.The first structure was based on geographic distinc-tions among member banks (table A.1). From 1913to 1962, reserve requirements of member banksvaried depending on whether the bank was locatedin a central reserve city, a reserve city, or else-where. In 1962, the authority of the FederalReserve to classify or reclassify cities as centralreserve cities was terminated.

In 1966, the Federal Reserve moved toward thenext structure, involving graduated reserve require-ments based on the level of deposits at each bank.Each deposit interval shown in table A.2 representsthat part of the deposits of each bank that wassubject to the reserve requirement shown. Forexample, in July 1966, the first $5 million of timedeposits at banks was subject to a 4 percent require-ment; each additional dollar of time deposits wasreservable at 5 percent. By 1972, a full-fledgedgraduated reserve requirement schedule was put inplace, without regard to reserve city or countrybank designations (table A.3).

Another change in reserve regulations involvedthe definition of ‘‘ net’’ demand deposits (tables A.1and A.2). In 1935, net demand deposits were de-fined as total demand deposits minus cash items inthe process of collection and demand balances

10. Required reserve balances as a percentage of total Federal Reserve liabilities, year-end, 1960–91

10

20

30

Percent

1960 1965 1970 1975 1980 1985 1990




The appendix continues on page 588.

A.1. Reserve requirements based on geographic distinctions among member banks, 1913–66Percent of deposits

Effective date

Net demand depositsTime deposits

(all classes of banks)Central reservecity banks

Reserve citybanks Country banks

1913—December 23 . . . . . . . . . . . . . . . . . . . . . . . . . 18 15 12 5

1917—June 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 10 7 3

1936—August 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19.5 15 10.5 4.5

1937—March 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22.75 17.5 12.25 5.25

May 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 20 14 6

1938—April 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22.75 17.5 12 5

1941—November 1 . . . . . . . . . . . . . . . . . . . . . . . . . . 26 20 14 6

1942—August 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

September 14 . . . . . . . . . . . . . . . . . . . . . . . . 22

October 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1948—February 27 . . . . . . . . . . . . . . . . . . . . . . . . . . 22

June 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

September 24, 16 . . . . . . . . . . . . . . . . . . . . . 26 22 16 7.5

1949—May 5, 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 21 15 7

June 30, July 1 . . . . . . . . . . . . . . . . . . . . . . . 20 14 6

August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 13 6

August 11, 16 . . . . . . . . . . . . . . . . . . . . . . . . 23.5 19.5 12 5

August 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 19

August 25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22.5 18.5

September 1 . . . . . . . . . . . . . . . . . . . . . . . . . . 22 18

1951—January 11, 16 . . . . . . . . . . . . . . . . . . . . . . . . 23 19 13 6

January 25, February 1 . . . . . . . . . . . . . . . . 24 20 14

1953—July 9, 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 19 13

1954—June 24, 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 19 13 5

July 29, August 1 . . . . . . . . . . . . . . . . . . . . . 20 18 12

1958—February 27, March 1 . . . . . . . . . . . . . . . . . 19.5 17.5 11.5

March 20, April 1 . . . . . . . . . . . . . . . . . . . . 19 17 11

April 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.5 17

April 24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 16.5

1960—September 1 . . . . . . . . . . . . . . . . . . . . . . . . . . 17.5

November 24 . . . . . . . . . . . . . . . . . . . . . . . . . 17.5 12

December 1 . . . . . . . . . . . . . . . . . . . . . . . . . . 16.5

1962—July 28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

October 25, November 1 . . . . . . . . . . . . . . 4

In this table and in table A.2, when two dates appear on the same line, thefirst applies to the change at central reserve city banks and the second appliesto the change at country banks.




due from other depositories. In 1969, reserves alsobegan to be required against net balances due fromdomestic offices to their foreign branches.

From June 21, 1973, through December 11,1974, under the structure of graduated reserverequirements, member banks were subject to vary-ing marginal reserve requirements against increasesin the following: (1) time deposits of $100,000 ormore; (2) funds obtained through issuance by anyaffiliate of the bank of obligations subject to reserverequirements on time deposits; and (3) funds fromsales of finance bills (table A.3). The requirementsapplied only to balances above a specified base:

They were not applicable to banks having aggre-gate obligations of these types of less than$10 million.

Beginning November 2, 1978, a supplementaryreserve requirement of 2 percent was added to theexisting requirements on time deposits in excess of$100,000 and for certain other liabilities. This sup-plementary requirement was eliminated with themaintenance period beginning July 24, 1980. Also,effective with the reserve computation periodbeginning November 16, 1978, domestic depositsof Edge corporations were subject to the samereserve requirements as member banks.

A.2. Reserve requirements based on geographic distinctions among member banks and on the level of deposits,1966–72Percent of deposits

Effective date

Net demand deposits Time deposits(all classes of banks)

Reserve city banks(deposit intervals inmillions of dollars)

Country banks(deposit intervals inmillions of dollars) Savings

Other time(deposit intervals inmillions of dollars)

0–5 More than 5 0–5 More than 5 0–5 More than 5

1966—July 14, 21 . . . . . . . 16.5 16.5 12 12 4 4 5

September 8, 11 . . 4 4 6

1967—March 2 . . . . . . . . . . 3.5 3.5

March 16 . . . . . . . . 3 3

1968—January 11, 18 . . . . 17 12.5

1969—April 17 . . . . . . . . . . 17 17.5 12.5 13

1970—October 1 . . . . . . . . 17 17.5 12.5 13 5

A.3. A graduated reserve requirement schedule for member banks, 1972–80Percent of deposits

Effective date

Net demand deposits(deposit intervals in millions of dollars)

Time and savings deposits

Savings

Time(deposit intervals in millions of dollars)

0–2 2–10 10–100

100–400

Morethan400

0–5, by maturity More than 5, by maturity

30–179days

180daysto 4

years

4years

ormore

30–179days

180daysto 4

years

4years

ormore

1972—November 9 . . . . . . 8 10 12 16.5 17.5 3 3 3 3 5 5 5

November 16 . . . . . 10 12 13 17.5

1973—July 19 . . . . . . . . . . . 10.5 12.5 13.5 18

1974—December 12 . . . . . 10.5 12.5 13.5 17.5 6 3 3

1975—February 13 . . . . . . 7.5 10 12 13 16.5 3

October 30 . . . . . . . 1 1

1976—January 8 . . . . . . . . 2.5 2.5

December 30 . . . . . 7 9.5 11.75 12.75 16.25 2.5 2.5




Effective with the maintenance period beginningOctober 25, 1979, a marginal reserve requirementof 8 percent was added to managed liabilities inexcess of a base amount. These liabilities includedlarge time deposits, Eurodollar borrowings, repur-chase agreements against U.S. government andagency securities, and federal funds borrowingsfrom nonmember institutions. This marginalrequirement was raised to 10 percent on April 3,1980, lowered to 5 percent on June 12, 1980, andthen eliminated altogether on July 24, 1980.

Since passage of the Monetary Control Act inNovember 1980, after an initial phase-in period, alldepository institutions have been subject to reserverequirements. Required reserve ratios are the samefor all depository institutions under the currentsystem and apply to transaction accounts andnontransaction accounts (table A.4). Transactionaccounts include all deposits on which the accountholder is permitted to make withdrawals by nego-tiable or transferable instruments, payment ordersof withdrawal, and telephone and preauthorizedtransfers (in excess of three per month) for thepurpose of making payments. The reserve require-ments on transaction accounts shown in table A.4apply only to those accounts that exceed theexemption and the low reserve tranche, the cutoffsfor which adjust each year according to a formulaprovided by law. In 1993, for example, the first$3.8 million of transaction accounts at each depos-itory is exempt from reserve requirements andthe next $46.8 million is reservable at 3 percent.Only deposits in excess of this low reserve trancheare reservable at 10 percent. For the purposesof reserve requirements, nontransaction accountsinclude nonpersonal time and savings deposits thatare not transaction accounts and in which the bene-ficial interest is held by a depositor that is not anatural person, as well as net borrowings by banksin the United States from banks outside the country.

SELECTED BIBLIOGRAPHY

Bank of Canada. ‘‘ The Implementation of Mone-tary Policy in a System with Zero ReserveRequirements,’’ Discussion Paper 3. (September1991).

Bernanke, Ben, and Frederic Miskin. ‘‘ CentralBank Behavior and the Strategy of MonetaryPolicy: Observations from Six IndustrialCountries.’’ Working Paper 4082, Cambridge,Mass.: National Bureau of Economic Research,1992.

Board of Governors of the Federal Reserve Sys-tem. ‘‘ The History of Reserve Requirements inthe United States,’’ Federal Reserve Bulletin,vol. 25 (November 1938), pp. 953–72.

Federal Reserve Bank of New York. ‘‘ ReducedReserve Requirements: Alternatives for the Con-duct of Monetary Policy and Reserve Manage-ment,’’ Staff Study (April 1993).

Goodfriend, Marvin, and Monica Hargraves. ‘‘AHistorical Assessment of the Rationales andFunctions of Reserve Requirements,’’ FederalReserve Bank of Richmond, Economic Review,vol. 69 (March/April 1983), pp. 3–21.

Horrigan, Brian R. ‘‘Are Reserve RequirementsRelevant for Economic Stabilization?’’ Journalof Monetary Economics, vol. 21 (January 1988),pp. 97–105.

Kasman, Bruce. ‘‘A Comparison of Monetary Pol-icy Operating Procedures in Six Industrial Coun-tries,’’ Federal Reserve Bank of New York,Quarterly Review, vol. 17 (Summer 1992),pp. 5–24.

Meulendyke, Ann-Marie. ‘‘ Reserve Requirementsand the Discount Window in Recent Decades,’’Federal Reserve Bank of New York, QuarterlyReview, vol. 17 (Autumn 1992), pp. 25–43.

Stevens, E.J. ‘‘ Is there any Rationale for ReserveRequirements?’’ Federal Reserve Bank of Cleve-land, Economic Review, vol. 27 (Quarter 31991), pp. 2–17.

Weiner, Stuart E. ‘‘ Payment of Interest onReserves,’’ Federal Reserve Bank of KansasCity, Economic Review, vol. 68 (January 1983),pp. 16–31.

. ‘‘ The Changing Role of ReserveRequirements in Monetary Policy,’’ FederalReserve Bank of Kansas City, Economic Review,vol. 77 (Fourth Quarter 1992), pp. 45–63.

A.4 Reserve requirements since passage of theMonetary Control Act of 1980Percent

Effective dateNet

transactionaccounts

Nontransactionaccounts

1980—November 13 . . . . . 12 3

1990—December 26 . . . . . 12 0

1992—April 2 . . . . . . . . . . . 10 0




Reserve requirements history, current practice, and potential reform

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