Why the Fed setting the Reserve Rate to 0% doesn’t matter for you.

by Werewolfdad

I thought I’d come explain to you why the Reserve Requirement Ratio being set to 0% doesn’t matter for you. There seem to be some significant misunderstandings about what it means, what the Reserve Requirement does, and how it affects consumers.

First, the Reserve Requirement is the amount of cash (or cash equivalents) banks must maintain on deposit at the Fed. This money is used to settle interbank transactions and to encourage banks to maintain a certain level of liquidity.

Second, if a bank’s reserve account is below the limit set by the Fed, they simply borrow from other banks, overnight, at the Fed Funds rate. Banks with excess reserves will lend money to other banks with insufficient reserves at the Fed Funds Rate. On balance sheets, these are recorded as Fed Funds Purchased and Fed Funds Sold. When the Fed Funds Rate is 0% (like it is now), banks can effectively borrow from each other for free (realistically, almost free, since they’ll still pay a few basis points). If the banks can’t borrow from other banks (due to credit concerns, for instance), the bank can borrow directly from the Federal Reserve at the Discount Window (which currently has a rate of 0.25% for primary credit and 0.75% for secondary credit) to maintain adequate reserves. Setting the reserve requirement to zero, simply means bank’s won’t need to borrow from the fed or from each other at a very nominal rate. It essentially eliminates a small expense for banks while greatly reducing accounting transactions and interbank liabilities.

So, what does this mean for the average depositor?

Nothing.

Just because banks don’t need to keep liquidity at the Fed, doesn’t mean they won’t. They just don’t need to incur an expense if their liquidity levels dip below the prior rate of 10%. Banks are also required to maintain Contingency Funding Plans (Funding and Liquidity Risk Management -Interagency Guidance) that creates a framework to ensure they maintain sufficient liquidity levels in times of stress and have sufficient contingent liquidity sources to meet their needs in those specific times of stress.

Additionally, large banks are subject to the Liquidity Coverage Ratio, which is a requirement of Basel 3 (which are basically international banking accords). This requires Large Banks to maintain sufficient liquid assets to cover 1 month of out going cash flows.

Will this cause my bank to fail?

Unlikely at this point. Compared to the 2008 crisis, banks are better capitalized, have better liquidity risk management processes (including the above mentioned contingency funding plans), and hold higher levels of liquidity. Banks are in a better position to defer borrowers, allowing them to recover before they become past due.

Does this mean bank’s can lend an unlimited amount of money?

No, NoNo, A thousand times no. This is the biggest misconception I’ve see (and honestly, the entire reason for my post). A reserve ratio of 0% does not mean banks can lend an unlimited amount of money. It means they can lend 10% more money (at most). Think of the reserve requirement as the minimum you need to maintain in your checking account before you start incurring maintenance fees. The Fed has simply waived that balance requirement and is waiving all the fees for everyone.

But what about Fractional Reserve Banking? Doesn’t that mean bank’s can lend out money they don’t have?

No. Per accounting rules, banks can’t lend out money they don’t have. For every dollar of assets (loans, investments, cash, etc), they need to have $1 in liabilities (deposits or loans)) or capital equity (surplus, retained earnings, etc).

IF a bank has $100 in liabilities/capital, the bank must have $100 in assets. If a bank has $200 in liabilities/capital, they must have $200 in assets. There’s a reason we call the balance sheet a balance sheet. Because it needs to balance.

Further, banks are constrained by their Capital ratio (Assets divided by capital). This is part of Basel II, Basel III, 12 CFR 3, 12 CFR 6, and various parts of interagency guidance. Leverage ratios are around 9% for Large bank holding companies, and 10% for other bank holding companies (www.federalreserve.gov/publications/2018-november-financial-stability-report-leverage.htm). This means banks are leveraged about 10 to 1. This is much different than the financial crisis when it was closer to 20-1. (5%). And certainly much higher than Lehman Brothers, which had a leverge ratio of 31-1 (or 3.2%).

I hope this effectively explains why the reserve requirement going to zero doesn’t matter for you.

Recommended Reading

www.thebalance.com/reserve-requirement-3305883

www.frbdiscountwindow.org/

www.occ.treas.gov/topics/supervision-and-examination/capital-markets/balance-sheet-management/liquidity/index-liquidity.html

www.fdic.gov/news/news/financial/2010/fil10013.html

www.investopedia.com/terms/l/liquidity-coverage-ratio.asp

www.federalreserve.gov/publications/2018-november-financial-stability-report-leverage.htm

TLDR: Removing the Reserve Requirement does not allow unlimited lending, eliminates the need for short-term borrowing despite the current nominal cost. Banks have other liquidity and capital constraints.

 

Disclaimer: This is a guest post and it doesn’t represent the views of IWB.