An important part of the post-crisis financial architecture is the liquidity coverage ratio (LCR), which requires banks to maintain sufficient liquidity to weather a 30-day period of severe idiosyncratic and market stress.  A key part of this framework is the concept of “high-quality liquid assets” (HQLA) – that is, assets that are and would remain highly liquid, even during market turmoil, and can easily be monetized to meet cash outflows (e.g., withdrawing depositors) during periods of stress.  Under the final U.S. LCR rule, assets that count as HQLA include excess reserves deposited at the Fed, Treasury securities, and certain other assets (primarily agency mortgage-backed securities) subject to a haircut. 

However, the current U.S. LCR rules don’t permit banks to treat as HQLA the funds that banks have deposited with the Fed to meet their reserve requirements.  We believe there are strong policy and legal reasons to begin treating required reserves as HQLA.

A brief primer on required reserves

Under the Federal Reserve Act, banks are required to hold vault cash or deposits at a Federal Reserve Bank equal to 10 percent of the their net transaction accounts (e.g., checking accounts).[1]  The Fed can also establish separate reserve requirements for selected other bank liabilities, such as savings accounts, but those requirements are currently set to zero. The vault cash and funds that the banks deposit with the Fed to satisfy this requirement are called “required reserves.”  Across the banking industry, this pool of funds is significant in size – for example, for the two weeks ending November 22, banks were required to hold $184 billion in reserves, of which $63 billion was met by vault cash and $121 billion met by reserve balances maintained at the Fed.  Because the Fed currently holds an immense portfolio of government securities acquired in the crisis, and those assets are funded mostly by deposits of banks at the Fed, total bank deposits with the Fed currently equal $2.3 trillion, well in excess of reserve requirements.  Balances in excess of required reserves are referred to as “excess reserves.”

 

Why don’t required reserves count as HQLA?

 

Given that both reserve requirements and the LCR require a bank to set aside liquid assets in proportion to their potential future withdrawals, it might be surprising to learn that the Fed has concluded that required reserves are not eligible for inclusion as HQLA.  This conclusion was the combined function of both the Basel Committee’s underlying framework for the LCR  and the Fed’s own policy with respect to required reserves.  On the former, the Basel Committee’s own LCR standard, on which the U.S. regulation is based, states that HQLA should include “central bank reserves (including required reserves), to the extent that the central bank policies allow them to be drawn down in times of stress.” [2]  And on the latter, the Fed’s Regulation D (which implements reserve requirements) states that “[a] depository institution … shall satisfy [its] reserve requirements”[3] and provides no exceptions for meeting the requirements.  Thus, as the Fed and the other banking agencies explained in their LCR final rule, the agencies considered and rejected a suggestion that required reserves be included in HQLA on the grounds that “the agencies do not believe that the assets held to satisfy a covered company’s required reserves would entirely be available for use during a liquidity stress event due to the reserve requirements.” [4]

 

Rethinking required reserves and their LCR treatment

 

Although this logic may hold on its own terms, required reserves need not and should not be excluded from HQLA under the LCR.  This is because there is no reason, as a policy matter, that the Fed should not permit banks to use and draw down their required reserves in a time of stress.

 

Although the precise nature and objective of reserve requirements have shifted over time, it’s been clear for some time that the only remaining purpose of reserve requirements is to serve as an important tool for the implementation of monetary policy.   This was made particularly clear when Congress enacted the Monetary Control Act of 1980, which amended the statutory scheme for required reserves (by applying it to all banks and not just Fed members banks) for the express purpose of “facilitat[ing] the implementation of monetary policy.”[5]  As a 1993 Federal Reserve Bulletin article on reserve requirements explains in more detail:

By helping to ensure a stable, predictable demand for reserves, reserve requirements better enable the Federal Reserve to achieve desired reserve market conditions by controlling the supply of reserves; in so doing, they help prevent potentially disruptive fluctuations in the money market.[6]

Interestingly, even this reason no longer applies.  The Fed is now controlling interest rates by oversupplying reserves, driving down interest rates to, or even a bit below, the amount of interest the Fed pays on excess reserves (that is, it is operating what is called a floor system for monetary policy).  As a result, it does not need a stable demand for reserves to achieve interest rate control.[7]  And although the FOMC is currently reducing the size of its balance sheet, including the amount of excess reserves, the Committee has indicated that it is inclined toward maintaining a floor-based system for implementing monetary policy in the future, and therefore would continue not to need reserve requirements in order to create a stable demand for reserves.[8]

Even if the Fed were to return to a monetary policy framework similar to its pre-crisis framework, allowing banks to use their required reserves under stress would not be a material impediment to conducting that policy.  For one, banks could provide notice if they planned on using the reserves, allowing the Fed to adjust their daily monetary policy operation.  But even absent any prior notice, the use of required reserves by banks causes the available supply of reserves to the banking system to go up and interest rates to fall, which is not a bad outcome on a day when banks are under stress.

Moreover, while the LCR makes banks safer, it requires banks to shift from illiquid assets (i.e., loans) to HQLA, and thereby also reduces credit availability and economic activity.  Allowing banks to use their required reserves when under stress would leave banks just as safe, yet permit them to increase their lending both in good times and in stress times, when the market is likely to need it most. 

This all means that there is no good reason for the Fed to prevent banks from drawing down on required reserves to meet outflows under stress, and plenty of good reasons to both allow it and therefore recognize required reserves as HQLA under the LCR.   Given that required reserves are for the foreseeable future irrelevant to monetary policy but would be highly relevant to a bank attempting to raise cash to meet outflows in a crisis, nothing would or should stop the Fed from amending Reg D to indicate that it will allow banks to utilize required reserves in order to meet liquidity needs during a time of stress.[9]  In fact, the Fed could use exactly the same language in Reg D that it included in the LCR final rule detailing the circumstances under which banks could use their required HQLA, temporarily falling below the LCR standard.  Specifically, the agencies established a notification requirement for any LCR shortfall, but also indicated their desire that “…supervisory actions should not discourage or deter a banking organization from using its HQLA when necessary to meet unforeseen liquidity needs arising from financial stress that exceeds normal business fluctuations.”  Those changes would, in turn, permit the Fed to treat required reserves as HQLA under the LCR.

Indeed, this seems to be exactly the result that Congress had in mind when it revised the statutory scheme for reserve requirements in 1980.  As part of those changes, Congress added a new provision to the Federal Reserve Act concerning required reserves:

The balances maintained to meet [reserve requirements] … may be used to satisfy liquidity requirements which may be imposed under other provisions of Federal or State law.[10]

This provision would seem to indicate that ensuring that required reserves get appropriate treatment under the LCR is not only good policy, but also precisely what the law requires.

 

 

 

 

^[1]       Net transaction accounts are total transaction accounts less amounts due from other depository institutions and less cash items in the process of collection.  Total transaction accounts consists of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturing in seven days or less. For further details, see www.federalreserve.gov/monetarypolicy/reservereq.htm.

 

^[2]       See Basel Committee on Banking Supervision, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools (Jan. 2013) at ¶ 49, available at www.bis.org/publ/bcbs238.pdf..

 

^[3]       12 CFR § 204.5(a)(1).

 

^[4]       See Liquidity Coverage Ratio: Liquidity Risk Measurement Standards, 79 Fed. Reg. 61440 (Oct. 10, 2014) (final rule) at 61456

 

^[5]       Pub.L. 96–221 at § 204.5(a)(1).  This purpose is also expressly stated in the Fed’s Regulation D, which notes that reserve requirements are “for the purpose of facilitating the implementation of monetary policy of the Federal Reserve System.”  12 CFR 204.1(b).

 

 

^[6]       See Joshua Feinman, Reserve Requirements:  History, Current Practice, and Potential Reform, Fed. Res. Bull. 569 (1993) at 569, available at https://www.federalreserve.gov/monetarypolicy/0693lead.pdf.

 

^[7]       See Laure Lipscomb, Antoine Martin, and Heather Wiggins, Why Pay Interst on Excess Reserve Balances (Sept. 27, 2017), available at http://libertystreeteconomics.newyorkfed.org/2017/09/why-pay-interest-on-excess-reserve-balances.html  For a quick overview of floor and corridor monetary policy implementation frameworks, see Bill Nelson, Liquidity and Leverage Rgulation, Money Market Structure, and the Federal Reserve’s Monetary Policy Framewok in the Longer Run (Sept. 2016), available at  https://www.theclearinghouse.org/-/media/files/association%20documents%202/20160921_tch_note_liquidity_and_leverage_regulation.pdf

 

^[8]       See Minutes of the Federal Open Market Committee July 26–27, 2016 at 3, available at www.federalreserve.gov/monetarypolicy/files/fomcminutes20160727.pdf.

 

^[9]       Alternatively, the Fed might simply issues guidelines or a similar statement making clear that they would waive deficiency charges for any failure to maintain required reserves under the those same circumstances.

^[10]     12 U.S.C. § 461(c).

 

 

 

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.