Zero-reserve banking: Another historic revolution.

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. Also, it was the beginning of the Covid crisis and I was paying more attention to the residents of my mother’s nursing home unit which was one of the first that Covid hit and over half of the dozen residents died during that first month. But there was surprisingly little attention to this revolutionary change in policy given it means that banks can, in theory, lend infinite amounts of money! That in turn would create massive instability because a bank with infinite loans would soon eliminate reserves and have zero ability to pay depositors who want to write checks or make withdrawals. Here is a Forbes report:

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!

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 (“quantitative easing”), but now that the Fed is paying the banks to hold reserves, it doesn’t have to require them to hold reserves 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 they were dodging. The Fed could have changed the rules to make dodging more difficult, but instead they started bribing the banks to keep 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. 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.

Eliminating reserve requirements is not “THE BOMB” because it has had zero impact on the world. The real bomb actually dropped back in 2008 when the Fed started subsidizing bank reserves for the first time in history. Almost nobody noticed except the banks and economics geeks, but it caused an explosion of bank reserves.

What the Fed should have done to stimulate the economy was to lower the interest rate on bank reserves to get the banks to hoard less money. That would have had a much bigger effect than eliminating the reserve requirements that everyone was ignoring.

Posted in Macro

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