wfhummel.net: The Role of Bank Reserves

A few brief excerpts from William F. Hummel's The Role of Bank Reserves, along with a few brief reactions.

Experience Has Shown...

A minimum level of reserves was once regarded as necessary to ensure that a bank could meet the withdrawal of deposits. However experience has shown that a well-run monetary system can operate successfully with no minimum reserve requirements.

Bill Hummel's article is a child of the Great Moderation. The article is dated 2/17/03. 2003. The same year Robert Lucas wrote that the "central problem of depression-prevention has been solved". Things did go along for quite some time, didn't they, in a way that was considered "Great". But things did not turn out so great in the end.

It may appear that "a well-run monetary system can operate successfully with no minimum reserve requirements". But appearances are sometimes deceiving. Perhaps we should say only that a well-run monetary system can operate successfully with no minimum reserve requirements for a while.

What's That?

Mr. Hummel writes:

Reserves comprise funds on deposit at the Fed plus vault cash.

This is important. It defines which money is counted as reserves. Something I forget all the time. Something worth trying to remember, Art.

• Funds on deposit at the Fed. This is, you know, people's bank balances, except the "people" are banks, and the "bank" that they bank at is the Fed.

• Vault cash. This is money that the banks have, that they have in their vaults, set aside in reserve (so to speak). Not the money in the drawer at the window where the teller might use it to cash a check for you today. Or maybe it is, I don't know. (I read that money in ATM machines is considered "in the vault." So maybe the teller's drawer money is in the vault, too.)

Anyway, the concept of "reserves" is that the money isn't circulating, but is kept aside because, who knows, somebody might need to withdraw their money today. (Hmm. If the teller's drawer money is not considered "in the vault", maybe it should be.) "A minimum level of reserves was once regarded as necessary to ensure that a bank could meet the withdrawal of deposits," as Mr. Hummel says.

Even with no minimum reserve requirement, banks would still have to hold enough reserves at the Fed to cover the checks written by their depositors, and enough vault cash to meet the demand for currency.

Money in reserve includes:
• Funds on deposit at the Fed to cover checks that must be cleared.
• Vault cash to meet the demand for currency.

Now perhaps I will remember what reserves are.

Reserve Money Bears No Credit Risk

The Fed and other clearing banks typically require payment in reserve money which bears no credit risk, rather than direct transfers between private banks which do bear a credit risk.

The Fed and other clearing banks typically require payment in reserve money which bears no credit risk

money which bears no credit risk

rather than direct transfers between private banks which do bear a credit risk.

So, what's that? Payment in reserve money bears no credit risk.

Payment in reserve money bears no credit risk, because it is money. It is not credit and it is not debt. Thank you, Mr. Hummel.

Thank you very much.

Reserves Influence Bank Lending

Mr. Hummel writes:

In the long run, reserve requirements can also influence the level of bank lending, deposit rates, and the quantity of credit and deposits.

It's like pulling teeth to find somebody willing to say that. But it is important.

How do central banks control the interest rate?

Canada imposes no minimum reserve on its banks. Its central bank, the Bank of Canada (BOC), freely lends overnight at its so-called bank rate to ensure that payment orders between banks will clear. That sets an upper limit on overnight rates. It also pays interest on any clearing balances that banks hold at the BOC at a rate 0.5 percentage point below the bank rate. That sets a floor on overnight rates. Volatility in the money market rate is effectively limited to within this operating range.

The BOC target rate is the midpoint of the range. In order to steer the overnight rate toward its target, the BOC conducts open market operations similar to those used by the Fed.

I'm sorry. How do central banks control the interest rate?

In order to steer the overnight rate toward its target, the BOC conducts open market operations similar to those used by the Fed.

Oh, I get it. They buy or sell securities in the open market, changing the quantity of money in the economy in order to influence the interest rate. Got it.