Zero-reserve banking: Another historic revolution.

Updated 10/25/2023

The Fed eliminated all reserve requirements for banks on March 16, 2020 for the first time in history and I didn’t even know about it until today because it got very little press, perhaps because it was the beginning of the Covid crisis.  Personally I was paying more attention to the residents at my mother’s nursing home where over half of the residents on her unit died during that first month.  It was one of the first places in the country that Covid hit and public health workers had to swoop in from out of town to keep the place running.  

But there was surprisingly little attention to this revolutionary change in policy given that the old textbooks say it means that banks could, in theory, lend infinite amounts of money!  Actually bank lending is still limited by their ability to find enough profitable borrowers and the FDIC still maintains capital requirements, so the old textbooks used outdated logic.  Here is a Forbes report about it:

The Federal Reserve just did enough to rate a “very happy” by …President Trump. That alone tells you they fired a big gun…

Reserve requirements cut to zero. THIS IS THE BOMB!

Going back in all of history, banks have been required to hold reserves against their assets – which are loans and securities. It’s simple – banks set aside a percentage of their assets as reserve and kept it in gold (for most of recorded history) or as cash at the Federal Reserve. This is a fundamental pillar of fractional reserve banking. Conceptually, the reserve gives depositors confidence that when they show up to take their money back, there will be cash to give them. It hasn’t always been nearly enough and if depositors get wary, they “run” to the bank to withdraw their money. Please re-watch “It’s a wonderful Life’ to see what happens during a bank run. It’s not pretty. It hasn’t just happened in black and white either. There were runs in 2007 and 2008 as depositors feared for their funds at several banks.

During the over 100+ years of Fed history, they have mandated the bank reserve ratio. Manipulation of the reserve requirement ratio has been one of their most powerful tools. That ratio was north of 20% through most of the first fifty years of the Fed (including the great depression). It had made its way down to 10% – that was before today. Until further clarification or notice, banks need not hold any reserve against their assets. This means that banks could theoretically continue making loans to infinity.

This is a shift to what the Fed is calling an “ample reserves regime.” Another reason it didn’t get much attention is because it didn’t cause bank reserves to drop at all. Bank reserves actually doubled between the month before the announcement and the month afterwards due to the emergency Fed actions to boost reserves during the start of the pandemic!

The real revolution in central banking that made this possible had already happened in 2008 when bank reserves first soared. Before that, bank reserves had always been as small as possible which means that the banks only held the minimum that they were required to hold. Since 2008, banks have had orders of magnitude more reserves than they were required to hold, so the reserve requirement hasn’t mattered since then. The big change was mainly due to the Fed deciding to pay interest to the banks on their reserves for the first time in history. That was a perverse action that delayed the recovery and blunted the effects of the massive monetary stimulus (called “quantitative easing”), but now that the Fed is paying the banks to hold reserves, it doesn’t have to require them anymore.

The Fed argues that it is better to pay interest on required reserves because:

If reserves are not remunerated, then forcing a bank to fulfill reserve requirements is similar to imposing a kind of “reserve tax.” Banks would be willing to hold a certain amount of reserves for self-interested reasons. Beyond that level, banks will take action to avoid [it]…

They do have an valid argument that most banks had already figured out how to avoid the reserve requirement, so there was no point in having a reserve requirement that was not binding. Generally banks have always made decisions about what loans are profitable and then looked for reserves if needed because banks usually borrow reserves cheaply from the Fed or other banks.  So the reserve ratio wasn’t ever particularly binding. 

The Fed could have changed the rules to make dodging more difficult, but instead they started bribing the banks to keep more reserves. The timing was perverse because it was during the 2008 economic crisis when banks started hoarding massive excess reserves and the problem was too much bank reserves rather than too little. The Fed claims that paying the banks to hoard excess reserves makes them more efficient, but it makes no sense to subsidize such excessive amounts of reserves. Excess reserves aren’t being used by definition. It is just being hoarded in the bank vaults where it does no good.

But paying the banks to hoard money that they don’t need IS a way to subsidize the banks and I’m sure the bank lobby is thrilled.  Brookings argues that the subsidy is minimal, but that was when the interest rate was minimal and it was still enough of a subsidy to cause an enormous explosion in reserves for the first time in history:

Eliminating reserve requirements is not “THE BOMB” because it had zero impact on the world. The real ‘bomb’ dropped back in 2008 when the Fed started subsidizing bank reserves for the first time in history.  When the Fed pays higher interest rates on reserves, that increases bank incentives to boost reserves, and the current subsidy for holding reserves is 5.4%. That is serious money.  In fact, the Fed is currently subsidizing the bank reserves at approximately $14 billion dollars per month!! 

Although the net effect is contractionary because the Fed is paying banks to get them to lend less money to the public, this also meets the definition of a helicopter drop because the Fed is giving billions of dollars of newly ‘printed’ money to private banks every month. 

Once the Fed started paying interest on reserves, the banks immediately ignored the reserve requirements.  Now, when the Fed wants to stimulate the economy, they can lower the interest rate on bank reserves to try to get the banks to hoard less money in reserves and lend out more.  Right now they want less lending because they want to hold down inflation.  It seems weird to be paying the banks a lot more money to get them to reduce lending and inflation but that is why the Fed is paying the banks so much money.  

The Fed touts paying interest rates on bank reserves as a new tool of monetary policy, but during the first four years of the new policy, it had the opposite effect from what the Fed said they wanted. The Fed wanted the banks to loan out more and by paying them to hoard reserves, the Fed was reducing bank loans.  The interest rate the Fed pays on reserves acts as a ceiling on the federal funds rate which helps the Fed control that rate.  

It may seem odd that the interest on reserves is a ceiling to the federal funds rate and not a floor. Because the federal funds rate is how much banks pay to borrow overnight funds from each other, some economists thought that banks would borrow at the federal funds rate and deposit the money at the Fed to gain the higher interest on reserves. But the FDIC charges for insuring all assets including reserves and the banks are required to hold costly equity capital to maintain their leverage ratio which also cuts into the profitability of holding reserves. Plus, nonbank institutions like the GSEs and the FHLBs also hold deposits at the Fed that do not earn interest and they would be willing to borrow on the federal funds market for less than the interest rate paid by the Fed.