Wednesday, March 11, 2009

Why doesn't the fed lower the required reserve ratio?

One of my students came up with a very interesting question.

US banks are still logjammed with toxic assets, and the US government is spending a lot of money it doesn't have bailing them out.

The same government is spending yet more money on a stimulus package.

Why doesn't it kill two birds with one stone and lower the required reserve ratio? Currently, it's at 10% for a large class of liabilities. (Full details at the link.)

For non-economists: Banks are in the business of lending money, not storing it. They want to lend as much as possible, and charge interest for it. The problem is that every now and then, depositors knock on their door and ask for their money back. In cash. At once. Because of this, banks can't lend ALL the money they receive. They need to keep some in reserve. The reserve ratio is the percentage of the money they take in that they need to keep in storage, just in case. In the US, this is 10%, by law (with some exceptions, see the link). In Canada, we haven't had a legally mandated reserve ratio since 1994. Our banks keep about 4.5% reserves.

Suppose the US lowered its mandatory reserve ratio to 5%, which is still higher than the ratio that Canadian banks chose on their own. All of a sudden, banks would have a whole bunch of extra cash on hand to work with. Well, okay, so most of it wouldn't actually be cash, but the idea's the same.

Provided you believe that giving bailout money to the banks will help them, then you should also believe that allowing the banks to dip into their piggy banks should help them.

The main exception to this that I can think of is that if the drop in reserve requirements is too quick and too large, investors could panic and cause a bank run. Because banks have most of their money tied up in loans and such, they can get into trouble if everyone asks for their money back at once. Mind, this trouble is always present...

A fall in the reserve ratio works very much like an injection of money, and will tend to boost the economy in the short run. (SOMEONE is getting that unfrozen money, after all.) In the long run, it all washes out, because eventually prices adjust to the new amount of cash. The kicker is that lowering the reserve ratio also 'powers up' later injections of money - so, if what the government wants to do IS pour money into the economy for a short-term band-aid while they figure things out, and if they're willing to put up with higher prices later on, lowering the reserve ratio would help.

So, why DOESN'T the US use the reserve ratio as a policy instrument? It's run out of wiggle room with interest rates, but there's still at least 5 percentage points of reserve ratio to play with before reaching Canada's level.

Some possibilities:

1. The most convincing one: after years of being stuck at 10%, lowering the reserve ratio may trigger financial panic and bank runs.
2. Maybe the US wants to avoid higher prices in the future - this is odd, given that recently there was a fear of deflation (falling prices).
3. The US may have other plans for its monetary policy that require tighter cash.
4. The US government doesn't bother because it doesn't think it would be effective - after all, banks are logjammed for other reasons. (Though I AM of the opinion that US banks doing their best to dodge reserve requirements by turning mortgages, which probably count against reserves, into other securities that don't, are part of what got us into this mess.)

This is a very good question that I don't have a satisfactory answer two. Comments encouraged.

As for the student, he's earned himself a bonus mark.


Rick said...

Hi in your post you mention that "In Canada, we haven't had a legally mandated reserve ratio since 1994. Our banks keep about 4.5% reserves." I was just wondering how you know they keep any reserves at all. Is this published somewhere?


KyleBriggsForex said...

In 2008 banks lost the trust of a lot of people in the US, I dont think lowering their required reserve ratio so that they can move more money into risky assets would be a good idea. Look at JP morgan who just posted around a 5 billion dollar loss. Although this would help the banks that are cautious and only invest in less risky assets it would no doubt be abused by those that depend on large returns.