Bank Reserves: A Hot Potato

During the Q&A following Chairman Bernanke’s testimony before the Joint Economic Committee today, Senator Sanders said he was preparing legislation to prohibit the payment of interest on excess reserves, and, indeed, to require banks to pay to hold excess reserves. The idea was to “unlock” the excess reserves held by the banking system and get them out in the economy through more vigorous bank lending. Chairman Bernanke pointed out that individual banks might reduce their reserve position, but that the banking system as a whole could not. Fed open market purchases determine aggregate bank reserves and passing them from one bank to another like a “hot potato” would not reduce reserves.

Anyone who studied money and banking and read the Chicago Fed’s green booklet “Modern Money Mechanics” knows that the Chairman was correct. However, given the lack of understanding of modern money mechanics that has been on display in recent years, it’s a sure bet that very few will understand Chairman Bernanke’s point. Let me explain.

The key to understanding is, first, to recognize how utilizing bank reserves to make more loans and investments do not diminish the amount of reserves in the banking system. The second point is to see how more lending and investing will not decrease total reserves, but will convert excess reserves into required reserves. This second point is what the questioner was getting at but didn’t articulate accurately.

If Bank A has plentiful excess reserves and buys $1 million of securities in the market, it will add the securities to its assets. It gives a check for $1 million to the seller of the securities, who most likely will deposit the check into their account of another bank, Bank B. (I know this is done electronically these days.) Bank A loses reserves to pay for its new securities. Bank B gets an equal amount of new reserves and an equal increase in its deposit liabilities. The reserves were lost to Bank A but went into Bank B, with no change in total reserves. However, Bank B has $1 million of new deposits to hold reserves against. At a ten percent marginal reserve requirement, $100,000 of excess reserves were converted into $100,000 of required reserves. The balance sheet effects are the same for a bank loan as for a security purchase. More bank loans or security purchases would not reduce total reserves, but would convert more excess reserves into required reserves.

This is only the first round effect, however. If the Fed buys $1 million of new securities in the market, it will add that much to the banks’ total reserves, one tenth of which will be required reserves and nine tenths of which will be excess reserves. If banks lend or invest all the excess reserves generated, the $1 million of total new reserves in the banking system will gradually convert excess reserves to required reserves. The process can go on until $10 million of new loans and investments are added to the banking system, which adds $10 million to the money supply. (10 is the reciprocal of 1/10)

Of course, what has been happening is that banks as a group are falling short of lending out or investing all their excess reserves, thus falling short of the potential money expansion. Despite over $2 trillion of assets being added to the Feds total assets, the equivalent amount of new reserves added to Fed liabilities remain, for the most part, excess reserves. This brings us back to my recent theme that, while people have assumed that the Fed’s purchases have created boatloads of new money, it simply hasn’t happened. M2 growth has averaged 7 percent or less per year during the recovery and that number has been cut about in half by a declining velocity of M2. The slow money growth has shown up in slower inflation and, more recently, falling gold prices.


Comments (10)

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  1. Eric says:

    Bob, ignoring whether Senator Sanders understands fractional reserve banking, wasn’t he really seeking to reduce the percentage of reserves held in excess system-wide? While the process of doing so might expand system-wide reserves, whether excess or required, I would have thought his point was to take that percentage of total reserves that are excess down to zero (or close to it). In this context, what are your thoughts on the merits of lowering interest rates on excess reserves or even charging to hold them? I can imagine it would lead to perverse incentives and froth, anytime investment decisions are forced upon the market.

  2. Eric says:

    I just saw your old posts….my question has been answered. Wonderful blog, Bob!

  3. JD says:

    Let’s say that the Senator wasn’t mistaken. Does he really think that this extra incentive is necessary to decrease excess reserves? Banks already have a huge profit motivation to loan everything out that they can.

  4. JD says:

    And if they are foregoing said profit, shouldn’t we be concerned about whatever is scaring them into keeping their money close?

  5. Dewaine says:

    I feel like principles of macroeconomics failed me.

  6. flow5 says:

    Paying interest on excess reserve balances is a credit control device (& a bad one). It induces dis-intermediation (an economist’s word for going broke); where the size of the SBs & NBs shrink, but the size of the CB system remains the same.

    Lowering the remuneration rate will increase reserve velocity (i.e., bank lending). But it also accomplishes something much more important. It unleashes the flow of savings through the non-banks (i.e., in the economic landscape, the world is still flat).

    These are the same economists that supported the elimination of Regulation Q ceilings (even though from a system’s perspective, CBs pay for what they already own). Getting the CBs out of the savings business does not reduce the size of the CB system. It does not reduce the volume of earning assests, or the income received by the system, or the opportunities of the CBs to make safe & profitable loans. 1966 is the paradigm.

    To the contrary, it increases the profits of the commercial banking system & alleviates the need for massive infusions of government credit. Bankrupt you Bernanke’s IOeR policy is VooDoo economics.

  7. August says:

    The idea of congress controling monetary policy makes me shudder. But reducing incetives to hold excess reserves will raise lending on the margin.

  8. flow5 says:

    M2 money supply & M2 velocity have no economic nexus. Economists fell back on M2 when they couldn’t link M1 to economic growth (see Humphrey-Hawkins Act required the Fed to set one-year target ranges for money supply growth twice a year).

    The relationship “broke down” because the Fed’s research staff used a contrived figure (income velocity) to measure money turnover (as opposed to the G.6 release). My forecast for AAA corporates for 1981 (when the relationship broke down) was 15.48%. AAA corporates hit 15.49% (i.e., no breakdown).

    Since Ed Fry discontinued the G.6 release in 1996 we have to fall back on the rate-of-change in required reserves for “e-bound” banks. RRs are linked to transaction based accounts 30 days prior (only as the weighted arithmetic average of reserve ratios & reserveable liabilities remains constant).

    There’s a 10 month roc (the proxy for real-output), & a 24 month roc (the proxy for inflation). These lag effects (or roc’s) have been mathematical constants for the last 100 years (not “long & variable” as pontificated by Friedman).

  9. flow5 says:

    From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, & probably its legal reserves (gratis – not a tax), & thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other CBs (e.g., an outflow of cash & due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit.

    Thus IBDDs (excess reserves) are indeed “lent” from the standpoint of an individual bank (have reserve velocity) but are not destroyed from a system’s perspective (unless Federal Reserve Bank credit on the BOG’s balance sheet changes).

    I.e., CBs need clearing balances to lend (from an individual bank’s perspective), but these “reserves” are either re-deposited within the same institution, or shifted to (clear thru) other CBs (reflecting the distribution of reserves from the system’s perspective). I.e., they are either derivative or primary inter-bank demand deposits (IBDDs) to member banks, but just a change in the composition of IBDDs for the system.

    Even with CB credit expansion, total reserves remain the same, but their form may change if excess, or “precautionary” (liquidity) reserves need to be converted to legally “required” reserves (though since c. 1995, for our FRB system, reserves are no longer binding).

    Note: legal (fractional) reserves ceased to be binding c. 1995: because increasing levels of vault cash/larger ATM networks (in Dec.1959 liquidity reserves began to count), retail deposit sweep programs (beginning c.1994), fewer applicable deposit classifications (including the “low-reserve tranche” & “exemption amounts”) & lower reserve ratios (since Mar. 1980), & reserve simplification procedures (beg. July 2012 more liquidity reserves, eliminating contractual clearing balances, etc.), have combined to remove reserve, & reserve ratio, restrictions.

    So excess reserves may be depleted (if not offset by the “trading desk”), as “factors that affect reserve balances change” (as currency is issued or as System Open Market Account securities are sold or “run off”, etc).

    Fractional reserve (or prudential reserve) banking is a function of the clearing velocity of centralized bank deposits (based on interbank payments & settlements, i.e., liquidity backstops). Money creation is not a function of the volume of CB deposits. I.e., for the CB system, the whole is not the sum of its parts.

  10. Greg Magnus says:

    The government has been attempting to control monetary policy in this capacity for a long time. This is just another effort by the government to manipulate banks. Just like they did with HUD, and that caused a national financial crisis. While this may not have the exact same effect, we should beware of government intervention in the banking system.