Distributed Economics

The Reserve Requirement and the Equity Capital requirements are two very different things, which often, and not at all surprisingly, get confused.    The best explanation I’ve found so far for the reserve requirement for the US banks is provided by Federal Reserve Board’s Reserve requirements page. It is fairly clear from that description there that the reserve requirement is the difference between the amount that the bank has on deposit and the amount it can lend, and is required so that the Banks can handle day to day demands for cash and transfers.

The reserve requirement today is 10% for Net Transaction Accounts above $44 million in deposits, 3% below that. A net transaction account is broadly a current account. There is no longer a reserve requirement for time deposits, which are presumably savings accounts with access restrictions.This amount of money either has to be present in the Bank’s vaults, as physical cash, or on deposit at the Federal Reserve, as a reserve.

Requiring the Banks to have some amount of physical cash, and/or a fixed percentage deposit of their total deposits at the Federal Reserve, is a way of synchronising the entire system. From a distributed systems perspective, this can be very important, if you want agreement between independent agents on say, a fixed ceiling on the amount of money or credit that the entire system can supply. There’s a nice distributed systems proof called the Fisher consensus problem, which shows that it is impossible to guarantee agreement without some element of synchronisation (which generally means a central point of some kind) between the distributed members of a system. However, it’s not entirely clear that the Federal Reserve understands it this way.

There is a very interesting paper from the Federal Reserve by Joshua N. Feinman, called Reserve Requirements: History, Current Practice, and Potential Reform. The paper reviews current and past reserve requirements and the reasons for them, at least according to the Federal Reserve.

Perhaps the most interesting thing about the paper is what it doesn’t say. At no point does Feinman discuss reserves as an integral part of systemic regulation of the loan and money supplies. In the main, the paper is about avoiding undue quantity of reserves – because of the cost to the banks of maintaining them (cost of deposits, with no loan income to match), and providing the necessary liquidity to meet day to day requirements. Which it seems, the Federal Reserve believes it has solved by being the lender of last resort, and providing shortfall funds to the banks whenever they need them.

A Bank’s equity capital is something quite different. This is the capital that was used to found the bank – it is a completely separate pile of funds to the deposits that are held by the bank. Nominally, this is the money the founders had to provide in order to be allowed to setup a bank in the first place. It is also referred to as Tier 1, 2 or 3 capital following the Basel accords. Equity capital is also generally what is meant when the problem of recapitalizing the banks is referred to.

When Banks take a loss on their loans, they first cover the loss from profits. In the absence of profits, they use their equity capital. That in and of itself can create problems, given that money then has to be brought in to replace the equity capital, which nominally at least reduces the amount on deposit, and hence the amount that can be lent.

Which returns to the problem of controlling the loan or credit supply for the whole banking system – i.e. how much in total are the Banks allowed to lend – and what in fact controls it? The reserve requirement – as implied by Feinman, or the amount of equity capital held by the banks, as implied by the Tier 1 and 2 capital ratio’s reported in every bank’s call report?

Who really controls the loan supply? The federal reserve? Or the commercial banks?

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All Banks licensed to operate within the United States of America have to file detailed quarterly reports on their lending and deposit status with the Federal Financial Institutions Examinations Council (FFIEC). These are known as banking Call Reports, and since 2001, are available for download, and public examination.

If there’s any kind of guide to reading and understanding them, I’ve yet to find it. Still, it’s amazing what can be done with python scripts, and a little patience.

There are two ways to get call reports – either as a consolidated set of files for all the banks per quarter, or individually per bank. It’s easier to understand call reports by looking at the individual consolidated ones, but for systemic analysis, the consolidated files can’t be beaten. It’s also useful to know that in the consolidated files, the Bulk POR report has the names, addresses and FDIC/IDRSSD numbers for all the Banks, which can otherwise be quite hard to find.

So, taking the Citibank FDIC #27606 call report for December 2001, we can  find the ratio of deposits, reserve and loans – at least, we can with a little decoding.

Deposits are known as liabilities in the alternative universe of Bank accounting. Total liabilities, are RCON2948; Total Equity Capital is RCON3210, and Total loans and leases are RCON2170. The forms aren’t completely consistent. For Wachovia, the RCON3210 field is missing, but RIAD3210 is listed as Total Equity Capital, Total Liabilities come under RCFD3300, Total loans are still under RCON2170 though. So in tabular form:

Then there is the question, which Citibank? For the big banks, there often seem to be several separate listings. There is also Citibank Delaware, Citibank New York State, Citibank Nevada, Citibank (South Dakota), and a couple of others.27606 is Citibank USA, using the form for a Bank with domestic offices only.

Another interesting question, in which field are the reserves? Equity capital is normally used to refer to the capital invested in a firm by its owners. So this would presumably be the capital reserve, which is the money used to found the Bank. It also matches the Tier 1 Capital entry, RCON8274.  Presumably then, the reserve of deposits referred to in textbooks, is not listed separately, but is simply the excess of deposits over loans. For which, for Citibank at least in December 2001, would appear to be  -$109,040,000. Interesting.

Actually, it gets worse further down the form. In RC-R the Regulatory Capital section, where Total Risk Weighted Assets are $2,470,549,000 (RCONA223).

Wachovia’s numbers also seems a little strange, since and at least in 2001, they were somewhat over capitalised. However, they seem to be reporting some kind of change to Equity Capital of $6,819,394,000 and it looks like they spent 2001 merging with First Union, which might explain it.Their Total Assets (loans) really are exactly equal to their Total Liabilities(deposits). I’m afraid most engineers, almost innately, tend to find exact matches like that suspicious as hell.

So from the empirical evidence, it seems that Banks can lend out as much as they have on deposit, and the Equity Capital reserve is in fact, the shareholders capital investment into the Bank, and is completely separate to the money deposited by the customers. Banks are required by the Basel treaties to maintain a minimum leverage ratio between theri Equity Capital and their Loans, which Citibank is within the limits of. (RCON7204-6). Presumably this explains why Citibank can get away with lending more money than it has on deposit, it’s still within its ratio with respect to its equity capital.

All the same, it seems a little strange. So, pausing only to drop this lot into a nice little sqlite database, next time I think we’ll look at the figures for some of the banks that have failed this year, versus some hopefully healthy ones, and also look at the situation across the eight years of data available.

One thing can be said though. The Murray Rothbard claim, that Banks can lend ten times their deposits, is shall we say, not supported by the available data.

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cc Empirical Analysis, Fractional Reserve System, Prologue