Banks rightly object to holding non-interest-bearing reserves at the Federal Reserve because they effectively are a tax on reservable deposits. Rep. Jack Metcalf has introduced legislation, endorsed by Fed Chairman Alan Greenspan, to direct the Fed to pay interest on reserves.

But there is a better way to resolve this problem: simply abolish reserve requirements.

Abolition offers one great advantage over paying interest on reserves- the cost to the federal government of losing the interest-free loan that reserve balances represent can be offset substantially, if not entirely, with expense savings at the Fed and the Treasury Department. On the other hand, paying interest on reserves will increase Fed operating costs.

Although the size of the loan has declined substantially as banks have used retail sweep accounts to minimize the amount held in transaction accounts subject to reserve requirements, at times reserve balances still exceed $10 billion.

Mr. Greenspan predicts that sweep accounts will pull reserve balances even lower, to the $3 billion to $5 billion range. As reserve balances drop, it becomes easier financially for Congress to simply abolish the reserve requirement.

As a plus, abolition would save the banking industry $150-$200 million annually in the administrative cost of complying with reserve requirements; administering sweep accounts has increased this compliance cost. Paying interest on reserves would not significantly lower compliance costs.

Although it is much cheaper from the government's perspective to abolish reserves than pay interest on them, the Fed would object mightily to abolition, but for specious reasons.

Specifically, the Fed would argue that banks must hold reserves at the Fed so that it can properly execute monetary policy. Like the Fed's assertion that banks receive a deposit insurance subsidy, this assertion, too, would be complete nonsense.

Reserve requirements, interest-bearing or otherwise, are not needed to execute monetary policy, for two reasons.

First, the Fed does not use reserve requirements to control the money supply by limiting the amount of reservable deposits that banks hold.

Because monetary policy has long consisted of interest rate signals that the Fed sends to the financial markets, it is physically impossible for the Fed to simultaneously control the money supply. Instead, as the Fed readily admits, it supplies the banking system with whatever quantity of reserves banks need to meet their reserve requirement.

Ironically, the Fed's recent proposal to shift from contemporaneous to lagged reserves makes a mockery of any contention that the Fed uses reserves to control the quantity of reservable deposits. This is the case because, under this proposal, the two-week period for which a bank's reserve requirement would be computed would end 17 days before the start of the two-week period for which reserves must be maintained.

Presently, the reserve computation period overlaps the reserve maintenance period by 12 days. Theoretically, then, the Fed can, though its open market operations (buying and selling Treasury securities), manipulate the quantity of reserves to influence the quantity of reservable deposits. It loses that ability with lagged reserve requirements.

The second reason reserve requirements are not needed to execute monetary policy is that monetary policy today essentially consists of the Fed's periodic announcement of its federal funds rate target. The target rate is the device the Fed uses to peg the short end of the interest rate yield curve.

Granted, through its open market operations the Fed can control the actual rate at which banks lend money to each other on an overnight basis. However, open market operations are a kabuki dance, since the Fed's transactions are minuscule compared to total trading volume in debt securities. Consequently, changes in the overnight rate should not have any impact on other short-term interest rates.

Since February 1994, when the Fed began publicly announcing its federal funds rate target, only those directly involved in managing reserves pay any attention to the actual overnight rate.

This conduct emphasizes the point that the execution of monetary policy consists solely of the Fed's interest rate signal, not its open market activities.

Abolishing reserve requirements would not impair the Fed's ability to periodically announce the rate target, although it is highly questionable for the markets to heed the Fed's opinion regarding the appropriate level of short-term rates. That discussion, though, lies beyond the scope of this article.

The argument for abolishing reserve requirements was best summarized by Mr. Greenspan himself, in a letter to Sen. Alfonse M. D'Amato:

"Elimination of reserve requirements would reduce the costs of financial intermediation for depositories through a number of channels. It would remove the reserve tax and the costly efforts of depositories to avoid it. It would also remove a complex area of regulation of depositories, which is not needed for safety-and-soundness purposes."

I hope Congress will soon accept this sound advice.

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