Simplified Reserve Requirements

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Simplified Reserve Requirements

by Donna Wilson, Credit and Risk Management Specialist

The current set of rules governing the administration of reserve requirements for depository institutions and Federal Reserve Banks is quite complex. These complexities have developed over time; for example, there are the rules governing as-of adjustments for check errors and FR2900 data revisions, as well as using an excess or deficient reserve balance in a future maintenance period. In addition, some depository institutions are on a 7-day maintenance period, but only report FR2900 data quarterly, while some depository institutions are on a 14-day maintenance period, but report FR2900 data weekly.

Given the various complexities that have developed over time, the Federal Reserve has recognized the need to simplify them and has identified four changes to the rules that will do so. These changes, or simplifications, will significantly reduce the complexity, administrative burden, and operational costs associated with reserve requirements. They will coincide with changes being made to Regulation D, which governs reserve requirements, and Regulation J, which relates to check collections, including references to as-of adjustments. Not only will these changes reduce the administration of reserve requirements, but they will also maintain the integrity of reserve requirements in the implementation of monetary policy.

The Simplifications

The four simplifications are:

1. The contractual clearing balance program will end.
2. Direct compensation will replace as-of adjustments.
3. All depository institutions will have a common maintenance period.
4. A reserve balance requirement band will replace carryover and routine waivers.

 

These four simplifications will be implemented in a phased-in approach. In April 2012, depository institutions received written communications about the first two changes to be implemented on July 12, 2012: the termination of contractual clearing balances and the elimination of the as-of adjustments. Additional communications will be sent out later this year on the common maintenance periods for all depository institutions and the reserve balance requirement band to replace carryover and routine waivers for deficiencies.

The Termination of Contractual Clearing Balances

Federal Reserve Banks will be ending the contractual clearing balance program on July 12, 2012. A contractual clearing balance is the amount a depository institution agrees to maintain in its Federal Reserve master account, which is in addition to its reserve requirement balance. Balances held under a contractual clearing balance generate earnings credits. The earnings credits are used to offset Federal Reserve Bank service charges. Operating Circular 1, Account Relationships, will be amended with the clearing balance legal agreement termination authority.

Since the implementation in 2008 of the Federal Reserve paying interest on required and excess reserve balances, clearing balances have declined. Unlike earnings credits, there are no restrictions on how institutions use the interest on reserves. Although the clearing balance program will be ending, any unused earnings credits will expire 12 months from issuance and will continue to be applied on a first-in, first-out basis.

Elimination of As-of Adjustments

As-of adjustments are memorandum items that are used to correct the reserve balance position of a depository institution. These adjustments are caused primarily by errors in processing check cash letters and incorrect FR2900 data reporting. The amount of the as-of adjustment is usually determined by the impact back to the day the error occurred, and it is applied in the calculation of the reserve/clearing position of a depository institution. Historically, the Federal Reserve Bank was in the best position to correct reporting and transaction-based errors and to process the as-of adjustment associated with the correction.

Starting with the maintenance period on July 12, 2012, the Federal Reserve will no longer issue as-of adjustments for FR2900 deposit revisions to correct for data reporting errors by the depository institution. However, in order to maintain the integrity and accuracy of monetary aggregate calculations, depository institutions will still be required to submit FR2900 deposit revisions. As-of adjustments to correct for transaction and Reserve Bank errors will be replaced with direct compensation. Compensation will be calculated using the daily average federal funds rate and will result in either a direct debit or credit entry to an institution’s Federal Reserve account. All operating circulars are being revised to remove references to as-of adjustments and, where appropriate, add terms and conditions of direct compensation.

Common Maintenance Period

Today, institutions are required to manage their required reserves over either a one- or two-week maintenance period. In early 2013, all institutions will use a two-week maintenance period. The common maintenance period simplifies the existing maintenance period structure and reduces administrative and operational costs for institutions by eliminating the need to change maintenance periods in association with changes in deposit reporting frequency. The two-week maintenance gives institutions that previously had a one-week maintenance period greater flexibility to meet their reserve requirement. It should be noted that the common maintenance period only affects how the institution meets its reserve requirement and will not affect an institution’s FR2900 deposit reporting frequency.

Reserve Balance Requirement Band

The final simplification is the creation of a reserve balance requirement band to replace a specific dollar amount to satisfy the reserve requirement and eliminate carryover and routine waivers for deficiencies. The current rules for carryover recognize the challenges with managing required reserves to a specific dollar amount. Carryover is the amount of excess (credit) or deficient (debit) balances that depository institutions are allowed to move to the next maintenance period. Institutions can use that carryover amount in meeting their reserve requirement in the next maintenance period by either holding additional balances or decreasing the amount held.

Routine waivers are waivers for deficiencies under $25.00. Other routine waivers include waivers that were given once every two years if a depository institution met certain criteria. At this time, the details regarding how the band will be determined have not been finalized; however, it is envisioned that the band will be applied in a similar manner as it is today for contractual clearing balances. If an institution’s average balance falls below the band, a penalty would be assessed for reserve deficiency; balances above the band will be treated as excess balance and subject to interest on excess reserves. More information will be provided as it becomes available.

Summary

These four changes will help to simplify the rules for reserve requirements: eliminating as-of adjustments and replacing them with direct compensation, ending the contractual clearing balance program, introducing a common maintenance period for all depository institutions, and implementing a reserve balance requirement band to replace carryover and routine waivers.

In early April 2012, written notice was sent out regarding the elimination of as-of adjustments and the termination of the contractual clearing balances. Information on the last two simplifications, the common maintenance periods for all depository institutions and the reserve balance requirement band, will be provided later in 2012.

Information will also be available on the Reserves Central Resource Center. For more information on the simplifications, see the Federal Reserve notice.

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The FED has never cooperated by supplying continuous, comparable, & timely data. Supporting data is required for the proper investigation, subsequent proof, & ending conclusion, for any economic research.

Presently, new data overlays (wipes out) the archived data (perhaps when the old data was more accurate & best representative).. I.e., the FED doesn’t keep each iteration of a data series.

Statistical calculations & mathematical modeling are inconsistent, not because of faulty economic theories, but because of non-conforming, or non-existent, raw data.

"Reliance on the data compiled by Government agencies is subject to the limitations of all analyses based upon statistical aggregates, i.e., data cannot be compiled accurately, or by a method which conforms to rigid theoretical concepts."

Necessarily there are caveats, e.g., (as the weighted arithmetic average of the data remains constant).

When it comes to statistical forecasting (& time series analysis), non-conforming data (or non-existent raw data), is the primary problem. 

www.federalreserve.gov/releases/h3/hist/annualreview.htm

Break factors remove discontinuities (or "breaks") associated with regulatory changes in reserve requirements, such as the annual indexation of the low reserve tranche and the reserve requirement exemption.

www.federalreserve.gov/monetarypolicy/reservereq.htm

The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution. The Garn-St Germain Act of 1982 exempted the first $2 million of reservable liabilities from reserve requirements. This "exemption amount" is adjusted each year according to a formula specified by the act. The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent was set under the Monetary Control Act of 1980 at $25 million. This "low-reserve tranche" is also adjusted each year (see table of low-reserve tranche amounts and exemption amounts since 1982). Net transaction accounts in excess of the low-reserve tranche are currently reservable at 10 percent.

www.federalreserve.gov/reportforms/forms/FR_293020121025_i.pdf

Allocation of Low Reserve Tranche and Reservable Liabilities Exemption

 

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Financial Services Regulatory Relief Act of 2006:

"The act will also allow the Federal Reserve to pay interest on contractual clearing balances and excess reserve balances, two types of balances that depository institutions hold voluntarily at Reserve Banks. By helping to stabilize the demand for voluntary reserve balances, this authority may allow the Federal Reserve to implement monetary policy without the need for required reserve balances. In these circumstances, the Board--as authorized by the act--could consider reducing or even eliminating reserve requirements, thereby reducing a regulatory burden for all depository institutions. "

Law Passed to Pay Interest on Reserves, Effective in 2011:

The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve banks to pay

interest on reserve balances and gave the Board of Governors authority to lower reserve

requirements on all transaction deposits (applied to deposits above a certain threshold level) to as low as zero percent, from their previous minimum top marginal requirement ratio of eight percent. These changes are not effective until October 2011.
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The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves. Keynes's liquidity preference curve is a false doctrine.


The Board amended Regulation D (on July 12, 2012), Reserve Requirements of Depository Institutions: to simplify the administration of reserve requirements & "reduce the administrative burden & operational costs associated with reserve requirements").  This action commingles a bank’s liquidity reserves (contractual clearing balances) with the system's traditional credit control device (required reserves).

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Those who don’t follow legal reserves aren’t aware that the Fed overlays their data revisions. Any given a shortfall in RRs will be masked by the Fed’s attempts to rebalance the system. The flash crash of May 6th 2010 was the direct result of the Board’s mismanagement of the money stock. The 8% drop in RRs prior to the crash was later erased to reflect an increase in RRs. Anyone trying to run a time series will be fooled. I.e., the banks respond immediately to an injection of liquidity.

One shouldn’t confuse liquidity reserves with legal reserves. The only type of bank asset the Fed’s in a position to constantly monitor & absolutely control are interbank demand deposits owned by the member banks’ & held at their District Reserve Bank, or pre-1959 requirements pertaining to assets (like the ECB). This was the original definition for legal reserves.

Allowing the member banks to use liquidity (prudential) reserves to satisfy their legal reserve requirements makes the FRB-NY’s “trading desks” job of legal reserve management (monetarism) harder.


See BOG: "In place of carryover and routine penalty waivers, depository institutions will have a penalty-free band around their reserve balance requirements. A penalty-free band is a range on both sides of a reserve balance requirement within which an institution needs to maintain its average balance over the maintenance period in order to satisfy its reserve balance requirement. The top of the penalty-free band will be set as the institution’s reserve balance requirement plus a dollar amount equal to the greater of $50,000 or 10 percent of the institution’s reserve balance requirement. The bottom of the penalty-free band will be set as the institution’s reserve balance requirement less a dollar amount equal to the greater of $50,000 or 10 percent of the institution’s reserve balance requirement. A depository institution that maintains balances above its reserve balance requirement, but within the penalty-free band, will be remunerated at the interest rate paid on balances maintained to satisfy reserve balance requirements. Balances maintained above the top of the penalty-free band will be remunerated at the interest rate paid on excess balances.

The last maintenance period to which carryover and routine penalty waivers will apply is the maintenance period ending Wednesday, June 26, 2013. The first maintenance period to which the penalty-free band around reserve balance requirements will apply is the maintenance period beginning Thursday, June 27, 2013"

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Lagged vs. contemporaneous reserve accounting:
research.stlouisfed.org/publications/review/82/12/Reserve_Dec1982.pdf

Just as I can query my checking account balance, so too can the bankers monitor their balances.  No need for lagged accounting nor penalty-free bands.

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Note also that “applied” vault cash (that quantity used to meet reserve requirements) & “surplus” vault cash have both been excluded in the tabulations of the money stock.
“Applied” vault cash is included in the total & required reserve figures. Whereas “surplus” vault cash is omitted from required reserve figures. There are actually 2 different calculations for required reserves, the FRB-STL’s & the BOG’s. Note one major difference is that the BOG adds “surplus” reserves to its total & excess reserve figures.

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See also:

Two Measures of Reserves:
Why Are They Different? -- R. ALTON GILBERT

research.stlouisfed.org/publications/review/83/06/Measures_Jun_Jul1983.pdf

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There is no base regime. The Fed turned 38,000 non-banks (financial intermediaries) into 38,000 commercial banks via the DIDMCA of March 31st 1980. Then it reduced requirements to zero on nontransaction liabilities in 1990. Then it reduced requirements on transaction based accounts from 12% to 10% in 1992.  At the same time reserve avoidance (retail & wholesale sweep accounts) & larger ATM networks, eliminated the binding constraint of bank credit creation.

On June 27 “Simplified Reserve Requirement Administration” becomes effective.

By using the wrong criteria (interest rates, rather than member bank reserves) in formulating & executing monetary policy, the Federal Reserve will continue to be an engine of inflation.

The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves.

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www.thomaspalley.com/docs/articles/macro_policy/asset_based_reserve_requirements.pdf

Asset-based reserve requirements:

“This paper has argued for a new comprehensive system of financial sector regulation centered on asset-based reserve requirements. Such a system can be used to combat financial instability by giving policy makers the instruments needed to discourage excessive risk taking. It also facilitates the task of macroeconomic management by providing policy makers with additional instruments, allowing them to hit additional targets, including stock market prices. It can also be used to affect the allocation of credit, including discouraging excessive short-term foreign lending”

&

“Within the US, the financial regulatory framework of the New Deal era has
been largely bypassed by financial innovation and legal repeal. A significant
regulatory gap has diminished the stability of policy makers to control financial
markets”


How is it that new financial products are reviewed only after they have been introduced into the marketplace & not approved before they become a regulatory problem?

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4/10/2013 106509
4/17/2013 106509
4/24/2013 126267
05/1/2013 126267

Under simplified reserve accounting the May swing in required reserve balances was an astronomical 20,000 billion dollar swing.

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The new reserve requirement’s simplification process on 7/11/2103 missed the opportunity to report the volume, turnover, & distribution of an individual CB’s demand deposit balances in their District Reserve Banks (CB system).

The most glaring error was the failure to disclose (report separately), the volume of pass-thru correspondent balances utilized to satisfy legal reserve maintenance requirements (historically responsible for the pyramiding of reserves). With this change, the Fed’s research staff has obfuscated the salient differences between liquidity (varied by independently owned & managed BHC’s business plans), & required reserves (a Central Bank’s credit control device).

Since 1942 (until interest on reserves), commercial bank credit creation was a “system” process (our payment & settlement system is significantly interconnected). No bank, or minority group of banks (from an asset standpoint), could expand credit (& the money stock), significantly faster than the majority group were expanding.

When CBs expand credit, reserves ceased to be “binding” c. 1994. But when the FRB-NY drains reserves, it still induces a system-wide, contraction of bank assets & liabilities. Indeed, all economic downdrafts coincide with a contraction (or deceleration in growth rates), of required reserves (based on transaction deposits 30 days prior), & commercial bank credit (e.g., depending upon FASB off-balance sheet accounting).

An individual bank needs clearing balances to lend. These are either stored internally as its liquidity reserves, or if a bank’s balance is insufficient, may be bought in the interbank market (shifting the distribution of reserve balances, & tightening any expansion coefficient).

The BOG’s reconstruction reveals that: “The levels and growth rates of the two series are nearly identical”. I.e., the new figures are skewed more because of the change in lagged applied vault cash (from 2 weeks to 1 week), rather than eliminating contractual clearing balances, as-of-adjustments, or RAM adjustments.

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(1) Required reserve balances vaulted by $20 billion dollars from one reserve maintenance period to the next ($106,509b to $126,267b) or from 4/17/2013 to 4/24/2013. In a commercial banking system where bankers buy their liquidity (as opposed to storing their liquidity), that fluctuation created a short-fall.

RRs have not been binding on the upside of interbank bidding & clearing c. 1994, but whenever the FRB-NY drains reserves both CB assets & liabilities still contract.

(2) The rate-of-change in RRs (the 24 month proxy for inflation) rebounded in May coincident with a rise in the demand for loan-funds.