Paper for a conference sponsored by the Federal Reserve Bank of New York entitled Financial Innovation and Monetary TransmissionBank reserves ; Federal funds market (United States) ; Monetary policy

James A. Clouse

English

Research Papers in Economics

FRBNY Economic Policy Review / May 2002 69
Commentary
aul Bennett and Stavros Peristiani offer an interesting 
paper that marshals a good deal of empirical evidence to 
address an important policy question: do reserve requirements 
affect banks’ decisions concerning the quantity and 
composition of their reserve holdings? A key motivation for 
examining this issue is the fact that required reserves have fallen 
dramatically in recent years as reserve requirements have been 
reduced and as banks have implemented so-called sweep 
accounts for their retail customers.1 In fact, required reserves 
are down so much that many depository institutions now 
regularly meet their reserve requirements incidentally as a 
consequence of holding vault cash for business purposes. That 
is, many banks hold significant amounts of vault cash to stock 
automated teller machine (ATM) networks and to meet 
customers’ withdrawal requests—a move that banks would 
make regardless of the level of reserve requirements. In many 
cases, the levels of vault cash that banks hold to meet customer 
demands more than adequately meet reserve requirements.
However, Bennett and Peristiani reason that banks might 
manage their vault cash somewhat differently when not faced 
with binding reserve requirements. In this “unbound” 
situation, banks’ desired levels of vault cash holdings should be 
driven largely by inventory management considerations. The 
inventory management problem faced by unbound banks 
involves balancing two competing concerns. On the one hand, 
vault cash is expensive for banks to hold because it earns no 
interest and must be financed with interest-bearing liabilities. 
Moreover, banks incur storage and security costs for holding 
vault cash. On the other hand, banks need to meet customer 
demands for cash on a regular basis to maintain client 
relationships. The inventory management problem is similar 
for banks bound by reserve requirements, but with one 
important exception. In the case of bound banks, the interest 
cost of vault cash should not be an especially important factor 
in determining desired vault cash holdings. When banks are 
bound by reserve requirements, they must hold non-interest-
bearing deposits at the Federal Reserve to meet the 
requirements. For bound banks, then, any increase in vault 
cash held to meet customer demands—and the associated 
increased interest costs—would be offset by a decline in the 
level of non-interest-earning deposits at the Federal Reserve. 
Thus, unlike in the case of unbound banks, a marginal increase 
in vault cash holdings for bound banks does not imply an 
increase in the overall opportunity costs of holding reserves.
The authors investigate the vault cash management 
behavior of banks using data at the individual bank level. Their 
regressions include numerous variables, such as seasonal 
dummies, deposit growth, branch dispersion, and number of 
ATMs, which one can basically think of as proxying for 
customer demands for vault cash. The regressions also include 
the federal funds rate as a proxy for unbound banks’ 
opportunity costs of holding vault cash. Curiously, in the 
regressions, the coefficient on the federal funds rate is negative 
for both bound and unbound banks. As noted above, the 
James A. Clouse
James A. Clouse is chief of the Monetary and Financial Market Analysis 
section of the Division of Monetary Affairs at the Board of Governors of the 
Federal Reserve System.
The views expressed are those of the author and do not necessarily reflect the 
position of the Federal Reserve Bank of New York or the Federal Reserve 
System.
P70 Commentary
standard theory would suggest that the coefficient on the funds 
rate should, indeed, be negative for unbound institutions but 
should be zero for bound institutions. It may be that the 
negative coefficient on the funds rate for both bound and 
unbound institutions is a sign that the funds rate is picking up 
some of the effects of customer demand for vault cash that are 
not fully captured by the other right-hand-side variables in the 
regressions. That is, periods of high federal funds rates are 
probably associated with low customer demand for cash and, 
faced with lower customer demand, both bound and unbound 
banks would likely choose to lower their vault cash inventories.
Bennett and Peristiani might be able to control for this 
somewhat by focusing the regression analysis on institutions 
that have moved from bound to unbound status. For example, 
one could estimate an equation for vault cash holdings for 
individual institutions during a period when they were bound 
and then determine whether this equation significantly 
overpredicted actual vault cash holdings when those same 
institutions became unbound. If so, this could be taken as 
indirect evidence that banks lower their vault cash holdings 
relative to what they would otherwise hold when they face a 
significant positive opportunity cost.
Another possibility for sharpening the econometric work 
might be to write down a simple inventory model for vault cash 
and use the derived theoretical demands for vault cash to help 
specify the econometric equations. As it stands, the authors 
have specified intuitive vault cash equations, but the lack of an 
underlying optimizing framework makes it difficult to 
interpret the coefficients. One theoretical result that seems 
worth testing is that the level of required reserves should have 
no impact on the level of desired vault cash holdings for 
unbound and for bound institutions. As noted above, unbound 
institutions need not factor in the level of required reserves 
when deciding how much vault cash to hold. For bound 
institutions, too, an increase or decrease in required reserves is 
likely to be reflected primarily as an accompanying increase or 
decrease in the level of required reserve balances rather than 
vault cash.
As a final general comment, it might be appropriate for the 
authors to change the title of the paper to something more 
descriptive, such as “Factors Determining Banks’ Holdings of 
Vault Cash.” The current title, and to some extent the paper’s 
introductory paragraphs, tend to lead the reader to believe that 
the authors produce evidence that reserve requirements are less 
effective as an instrument for monetary control and for the 
implementation of monetary policy. For a time in the late 
1990s, it did appear that the declining level of required reserve 
balances in the System might make it more difficult for the 
Federal Reserve to keep the funds rate close to the target rate on 
a daily basis. During this period, daily funds rate volatility and 
demands for excess reserves seemed to be on the rise. However, 
consolidation in the banking system and various technological 
improvements since then seem to have allowed banks to 
economize on the level of reserve balances they need for 
clearing purposes. Thus, it appears that supply and demand in 
the federal funds market are still driven importantly by the 
needs of some banks to meet an average balance requirement 
over a maintenance period. Consistent with this hypothesis, 
daily funds rate volatility has been quite low in the last couple 
of years and demand for excess reserves has fallen back to 
historical levels. In this sense, one might argue that despite the 
marked decline in aggregate required reserves, reserve 
requirements—together with clearing balance requirements—
continue to be an important element in the current structure 
for the implementation of monetary policy.Endnotes
FRBNY Economic Policy Review / May 2002 71
1. The details of sweep accounts vary somewhat, but they basically 
involve sweeping balances above a certain threshold in customers’ 
transaction accounts into savings accounts. As customers write checks 
for various payments, funds are periodically swept back into their 
transaction accounts to cover those payments. The net effect is that 
transaction account balances are lower and savings account balances 
are correspondingly higher. Furthermore, reserve requirements do 
not apply to savings accounts, which implies that banks’ required 
reserves are lower on average.
The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York 
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the 
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in 
documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

Are U.S. reserve requirements still binding? commentary

http://www.newyorkfed.org/research/epr/02v08n1/0205clou.pdf

Are U.S. reserve requirements still binding? commentary

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