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Last
week, we were looking at what bank reserves are, the fuction they have in a
monetary and financial system, and typical reserve/deposit ratios over time.
March 6, 2011: Bank Reserves
We saw that, historically, banks held rather high reserves, which is to say,
that they held a high percentage of their total assets in the form of cash,
literally paper bills. This was so that they could meet any obligations that
could arise, and also reflected the availability of attractive lending
opportunities. Banks try to balance their desire to earn interest income from
loans, and also to be able to meet obligations.
Now
we will continue this chart with the situation from 1959 to the present:
 
The numbers here are direct from the Federal Reserve.
What we see is that during the 19th and the first half of the 20th century,
banks typically held reserves of 10% or more of their deposits, although the
ratio slipped below 10% during the Roaring '20s. Beginning around 1960, this
tumbles to much lower levels, ending up around 1% in the last couple decades.
In recent times, bank reserve holdings have risen to a much higher level
(15%), but take note that this much higher level was in fact a common level
in the past, and indeed was exceeded when banks were under great stress, as
in the 1930s (25%+).
Let's say a bank has an obligation, but doesn't have adequate cash (reserves,
base money) to meet it. For example, depositors may withdraw their money, or
depositors may draw down their accounts to meet some obligation, or some sort
of loan (CD, bond) may be coming to maturity. Maybe the bank just wants to
make even more loans. If the bank doesn't have the cash, it must borrow the
funds from someone else, typically another bank, at least for short-term
financing. On the other hand, let's say you are a bank with plenty of funds
(reserves, base money). You decide that you don't want to just sit on a big
pile of banknotes, which don't earn interest. You can lend the money to
another bank, and make a little money. So the banks that want to borrow funds
and the banks that want to lend funds meet on the interbank lending market.
This is the interbank lending rate. There are overnight (one day) rates, one
week rates, one month rates and so forth.
So the bank goes and borrows the money. But what if nobody lends money to the
bank? Then it defaults on its obligations, which leads immediately to
bankruptcy. Ouch. Why would a bank not lend money to another bank? Because a)
they don't think the bank will pay it back (credit risk), or; b) they don't
have the money to lend. If the bank's risk of not being able to borrow is
high, then the bank would tend to hold more reserves so that it doesn't need
to borrow. This is like holding more cash in your wallet if you think your
credit cards might be declined.
The Federal Reserve was created in 1913, but it didn't really become active
until about 1918 or so. This is about the point at which banks begin to lower
their reserve holdings below 10%. The Federal Reserve accomplished a couple
of things, compared to the situation before 1913. The first thing is that it
removed the risk of systemic liquidity shortage crises, which were a chronic
problem during the 19th century and culminated in the Panic of 1907. The
second thing is, the Fed provided an agent that could be appealed to if a
bank wasn't able to borrow from other banks due to credit risk fears. In
other words, a bank could borrow from the Fed if no other banks would lend to
it. The Fed was a "lender of last resort."
This reduced a bank's risk of not being able to obtain funding. So, over
time, in order to maximize profitability, banks held less and less reserves
until they held almost none at all.
Bank reserves, whether in the form of paper banknotes or Fed electronic
registry, are a form of base money. Naturally, as banks tend to hold less
reserves, the percentage of base money that consists of bank reserves has
fallen.
Here is a chart (once again from Friedman) that shows what percentage of base
money consisted of bank reserves. We
can see a sort of plateau around 40%.
And here are the more recent figures. We see that bank reserves fell to a
rather low portion of the monetary base. The recent spike higher returns the
figure to more like its historical levels.
Now we have some figures on the supply of bank reserves, a form of base
money. Later, we will
think about the demand.
Nathan
Lewis
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