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October 20, 2011

Just Released: Fed Proposes Simpler Rules for Banks’ Reserve Requirements

Richard Roberts*

Reserve requirements—a critical tool available to Federal Reserve policymakers for the implementation of monetary policy—stipulate the amount of funds that banks and other depository institutions must hold in reserve against specified deposits, essentially checking accounts. On October 18, 2011, the Fed proposed to simplify the rules that govern these requirements, with the aim of reducing cost and burden on depository institutions and on the Federal Reserve. The simplifications will also allow the Fed to modernize the infrastructure that supports reserve administration without compromising the role that reserve requirements play in the conduct of monetary policy.

    In this post, I summarize what the Fed proposes, which includes: 1) creating a common two-week maintenance period for all depository institutions, 2) sunsetting the contractual clearing balance program, 3) creating a “band” around reserve requirements to replace carryover, and 4) using “direct compensation” to replace as-of adjustments.

Establish a Common Reserve Maintenance Period

A reserve maintenance period is the time over which an institution must hold the daily average amount of reserves that the Fed requires it to hold. Today, smaller institutions generally use a one-week maintenance period, while larger institutions use a two-week period. Moreover, each year some switch from one length maintenance period to the other. Having two different maintenance periods does not serve a purpose for the implementation of monetary policy, and managing the dual system imposes costs both on depository institutions that switch between maintenance periods as well as on the Federal Reserve. The Fed proposes to implement a common two-week reserve maintenance period no earlier than the third quarter of 2012.

Eliminate the Clearing Balance Program

A clearing balance is an amount that an institution agrees to maintain with the Fed in addition to its reserve requirement. These extra balances earn implicit interest, known as earnings credits, which may be used to offset Fed service charges and reduce the risk of an overdraft to reserve accounts.

    Now that the Fed pays interest on reserves, there is no need for institutions to set aside a separate balance earning its own rate of return to pay for service charges.  Additionally, at current interest rates, the implicit interest rate that is paid on contractual clearing balances is below the rate paid on excess reserves. As a result, institutions could earn a greater return and use the earnings for any purpose by canceling their contractual clearing balance arrangement with their Reserve Bank. The contractual clearing balance program is cumbersome to maintain and requires legal agreements between depository institutions and the Federal Reserve.

    The Fed proposes sunsetting the contractual clearing balance program beginning no earlier than the first quarter of 2012.

End the Carryover of Excess/Deficient Reserve Positions

“Carryover” allows an institution with a small excess or deficiency of reserves in one period to use it or make it up in the following maintenance period.  In turn, the payment of interest on reserves is delayed by at least one maintenance period, because the subsequent maintenance period must be completed to account for the potential use of carryover.

    The Fed proposes creating similar flexibility by establishing a “band” of either a percentage or a dollar amount around each depository institution’s reserve requirement. If the depository institution maintained balances that were below the requirement, but still within the band, the depository institution would not be deemed to be deficient. Similarly, if a depository institution held balances that were above the requirement, but still within the band, it would not be deemed to be in an excess position. Only balances that fell outside of the band would be considered either deficiencies or excesses. Such an approach would be more straightforward and would allow interest payments to be accelerated.

    The Fed proposes to implement a penalty-free band around reserve balance requirements no earlier than the third quarter of 2012.

Eliminate “As-Of Adjustments”

“As-of adjustments” are issued by the Fed to neutralize the effect of a transaction-processing or deposit-reporting error on a depository institution's reserve position. In an environment where the Federal Reserve is regularly making interest payments on reserve balances, replacing transaction-based as-of adjustments with some form of direct compensation seems beneficial to depository institutions and the Federal Reserve. Depending on the correction that is needed, either a credit or a debit would be made to the depository institution’s account. This change would allow the Federal Reserve to remedy transaction errors more quickly and would result in reduced administrative burden. For these reasons, the Federal Reserve proposes to eliminate transaction-based as-of adjustments and replace them with direct compensation. As-of adjustments that result from deposit revisions would be eliminated.

    The Fed proposes to eliminate the use of as-of adjustments no earlier than the first quarter of 2012.

Bottom Line

The Board of Governors has requested comments on these simplifications by December 19, 2011. Should the modifications be implemented, the cost and burden on depository institutions and on the Fed should decrease. Additionally, the simplifications will allow the Fed to modernize the infrastructure that supports reserve administration without compromising the role that reserve requirements play in the conduct of monetary policy.

*Richard Roberts is an officer in the Research and Statistics Group of the Federal Reserve Bank of New York.

The views expressed in this blog are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

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