Reserve Requirements
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?
©cc
Pretty good post. I just came across your site and wanted to say
that I’ve really liked browsing your blog posts. Any way
I’ll be subscribing to your feed and I hope you post again soon!
An interesting discussion of what the mentioned Fed paper led to can be found at http://www.marketskeptics.com/2009/03/us-banks-operate-without-reserve.html
Regarding your closing question: Loan supply depends on social mood, really. It may or may not be true that banking crises have been engineered in the past, but that wouldn’t be possible today because too much information is disclosed. I’m not meaning to judge the central banking approach by saying this; I personally think there’s room for improvement. However, while a lot of information that’s disclosed these days simply doesn’t get any attention or requires a deeper understanding of matters, virtually everyone watches the central banks closely. The flaws of the system will allow one to criticise them regardless of their actions but they’ll not be able to get away with an intentional shortage of money supply.
Though the Fed having made itself more important as the lender of last resort is another topic indeed. Having bought all the toxic assets, the IMF might be the institution to address next, should these assets prove to be worth much less than their nominal value in the medium and long term.
This is really the topic of the next post, so i’ll punt on most of the reply. I don’t know of any major banking crises that have been deliberately engineered, but especially in the 18th and 19th centuries, there were a lot of small bank failures, some legitimately because the banks concerned were being run shall we say, with an absence of risk aversion, and some just through bad luck, crop failure, etc. A lot of today’s banking regulations derive from that experience, and one thing that’s probably worth bearing in mind – especially when reading people like von Mises, is that in many respects they are talking about a quite differently implemented system than the one we have today.
I have no doubt whatsoever, especially when inflation adjusted, that the toxic assets will turn out to be worth substantially less than their face value.
@cc
Some claim the banking crisis of 1907 was engineered, and why not. It must be tempting to be able to buy shares at the right point in time for virtuelly no money.
Given that the Fed, unlike many other central banks, pays a dividend to its undisclosed private shareholders it’s hard to imagine the central bankling scheme in the US was installed out of generosity.
I tend to think the same regarding the toxic assets. That’ll be interesting to watch.
It’s certainly possible. The more concentrated the wealth becomes under this system, the more problematic is that concentration in and of itself. Before the federal reserve was brought in as Lender of Last Resort, a large account being shifted between two banks, would have been enough to cause problems. If people knew that was the case…
The Americans copied the English/European system. At this point in history, the USA is not on the world stage in the way they are today, the British Empire is controlling the world’s financial system, with the Austro-Hungarian empire dominating on the mainland. The American banking system had experienced decades of instability and bank failures, which had not been seen in the British system after the Bank of England was installed as Lender of Last Resort.
I must admit, i do wonder how much they actually understood what they were copying – but that’s a question that requires access to more detailed historical references than I currently have.
– cc
The Money Masters seems to contain a lot of well researched facts, despite all the judgement that it’s combined with all the time (and which I don’t fully support). I haven’t had the time and resource access to double check all the facts. It requires quite some attention to separate the facts from the author’s opinion but once you manage to do it it’s worth viewing it, or so I think.
What I find most interesting about it is that it proves many historical claims by other people wrong.
As I see it, the author’s biggest mistake is to assume that fiat money was a good idea were it only issued by congress or the treasury instead of a central bank. there’s no historic evidence that such an approach would work better than with an “independent” central bank, and I personally tend to believe it’s because fiat money can’t really work unless money supply exactly matches economic development (which is unlikely if congress can create the money it needs without any consequences).
The showdown of the movie, however, is interesting because it outlines a way to abandon central banking and end fractional reserve lending. While I like this approach I don’t think it should be mixed with a shift of the issuing power. The Fed apparently being the only quasi private central bank in the world today, however, is a different topic — that should definitely end.
http://video.google.de/videoplay?docid=6076118677860424204 (pt 1)
http://video.google.de/videoplay?docid=-7336845760512239683 (pt 2)