Modern Money Mechanics 5
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Changes in Service-Related Balances
and Adjustments
In order to foster a safe and efficient payments system, the Federal Reserve offers banks a variety of payments services. Prior to passage of the Monetary Control Act in 1980, the Federal Reserve offered its services free, but only to banks that were members of the Federal Reserve System. The Monetary Control Act directed the Federal Reserve to offer its services to all depository institutions, to charge for these services, and to reduce and price Federal Reserve float.(13) Except for float, all services covered by the Act were priced by the end of 1982. Implementation of float pricing essentially was completed in 1983. The advent of Federal reserve priced services led to several changes that affect the use of funds in banks' reserve accounts. As a result, only part of the total balances in bank reserve accounts is identified as "reserve balances" available to meet reserve requirements. Other balances held in reserve accounts represent "service-related balances and adjustments (to compensate for float)." Service-related balances are "required clearing balances" held by banks that use Federal Reserve services while "adjustments" represent balances held by banks that pay for float with as-of adjustments. An Increase in Required Clearing Balances Reduces Reserve Balances Procedures for establishing and maintaining clearing balances were approved by the Board of Governors of the Federal Reserve System in February of 1981. A bank may be required to hold a clearing balance if it has no required reserve balance or if its required reserve balance (held to satisfy reserve requirements) is not large enough to handle its volume of clearings. Typically a bank holds both reserve balances and required clearing balances in the same reserve account. Thus, as required clearing balances are established or increased, the amount of funds in reserve accounts identified as reserve balances declines. Suppose Bank A wants to use Federal Reserve services but has a reserve balance requirement that is less than its expected operating needs. With its Reserve Bank, it is determined that Bank A must maintain a required clearing balance of $1,000. If Bank A has no excess reserve balance, it will have to obtain funds from some other source. Bank A could sell $1,000 of securities, but this will reduce the amount of total bank reserve balances and deposits. See illustration 24. Banks are billed each month for the Federal Reserve services they have used with payment collected on a specified day the following month. All required clearing balances held generate "earnings credits" which can be used only to offset charges for Federal Reserve services.(14) Alternatively, banks can pay for services through a direct charge to their reserve accounts. If accrued earnings credits are used to pay for services, then reserve balances are unaffected. On the other hand, if payment for services takes the form of a direct charge to the bank's reserve account, then reserve balances decline. See illustration 25. Float Pricing As-Of Adjustments Reduce Reserve Balances In 1983, the Federal Reserve began pricing explicitly for float,(15) specifically "interterritory" check float, i.e., float generated by checks deposited by a bank served by one Reserve Bank but drawn on a bank served by another Reserve Bank. The depositing bank has three options in paying for interterritory check float it generates. It can use its earnings credits, authorize a direct charge to its reserve account, or pay for the float with an as-of adjustment. If either of the first two options is chosen, the accounting entries are the same as paying for other priced services. If the as-of adjustment option is chosen, however, the balance sheets of the Reserve Banks and the bank are not directly affected. In effect what happens is that part of the total balances held in the bank's reserve account is identified as being held to compensate the Federal reserve for float. This part, then, cannot be used to satisfy either reserve requirements or clearing balance requirements. Float pricing as-of adjustments are applied two weeks after the related float is generated. Thus, an individual bank has sufficient time to obtain funds from other sources in order to avoid any reserve deficiencies that might result from float pricing as-of adjustments. If all banks together have no excess reserves, however, the float pricing as-of adjustments lead to a decline in total bank reserve balances.
Week-to-week changes in service-related balances and adjustments can be volatile, primarily reflecting adjustments to compensate for float. (See chart. ) Since these changes are known in advance, any undesired impact on reserve balances can be offset easily through open market operations. 13The Act specified that fee schedules cover services such as check clearing and collection, wire transfer, automated clearinghouse, settlement, securities safekeeping, noncash collection, Federal Reserve float, and any new services offered. back 14"Earnings credits" are calculated by multiplying the actual average clearing balance held over a maintenance period, up to that required plus the clearing balance band, times a rate based on the average federal funds rate. The clearing balance band is 2 percent of the required clearing balance or $25,000, whichever amount is larger. back 15While some types of float are priced directly, the Federal Reserve prices other types of float indirectly, for example, by including the cost of float in the per-item fees for the priced service. back End of page 22. back 24 When Bank A establishes a required clearing balance at a Federal Reserve Bank by selling securities, the reserve balances and deposits of other banks decline. back
25 When Bank A is billed monthly for Federal Reserve services used, it can pay for these services by having earnings credits applied and/or by authorizing a direct charge to its reserve account. Suppose Bank A has accrued earnings credits of $100 but incurs fees of $125. Then both methods would be used. On the Federal Reserve Bank's books, the liability account "earnings credits due to depository institutions" declines by $100 and Bank A's reserve account is reduced by $25. Offsetting these entries is a reduction in the Fed's (other) asset account "accrued service income." On Bank A's books, the accounting entries might be a $100 reduction to its asset account "earnings credit due from Federal Reserve Banks" and a $25 reduction in its reserve account, which are offset by a $125 decline in its liability "accounts payable." While an individual bank may use different accounting entries, the net effect on reserves is a reduction of $25, the amount of billed fees that were paid through a direct charge to Bank A's reserve account. back
Changes in Loans to Depository Institutions
Prior to passage of the Monetary Control Act of 1980, only banks that were members of the Federal Reserve System had regular access to the Fed's "discount window." Since then, all institutions having deposits reservable under the Act also have been able to borrow from the Fed. Under conditions set by the Federal Reserve, loans are available under three credit programs: adjustment, seasonal, and extended credit.(16) The average amount of each type of discount window credit provided varies over time. (See chart.) When a bank borrows from a Federal Reserve Bank, it borrows reserves. The acquisition of reserves in this manner differs in an important way from the cases already illustrated. Banks normally borrow adjustment credit only to avoid reserve deficiencies or overdrafts, not to obtain excess reserves. Adjustment credit borrowings, therefore, are reserves on which expansion has already taken place. How can this happen? In their efforts to accommodate customers as well as to keep fully invested, banks frequently make loans in anticipation of inflows of loanable funds from deposits or money market sources. Loans add to bank deposits but not to bank reserves. Unless excess reserves can be tapped, banks will not have enough reserves to meet the reserve requirements against the new deposits. Likewise, individual banks may incur deficiencies through unexpected deposit outflows and corresponding losses of reserves through clearings. Other banks receive these deposits and can increase their loans accordingly, but the banks that lost them may not be able to reduce outstanding loans or investments in order to restore their reserves to required levels within the required time period. In either case, a bank may borrow reserves temporarily from its Reserve Bank. Suppose a customer of Bank A wants to borrow $100. On the basis of the managements's judgment that the bank's reserves will be sufficient to provide the necessary funds, the customer is accommodated. The loan is made by increasing "loans" and crediting the customer's deposit account. Now Bank A's deposits have increased by $100. However, if reserves are insufficient to support the higher deposits, Bank A will have a $10 reserve deficiency, assuming requirements of 10 percent. See illustration 26. Bank A may temporarily borrow the $10 from its Federal Reserve Bank, which makes a loan by increasing its asset item "loans to depository institutions" and crediting Bank A's reserve account. Bank A gains reserves and a corresponding liability "borrowings from Federal Reserve Banks." See illustration 27. To repay borrowing, a bank must gain reserves through either deposit growth or asset liquidation. See illustration 28. A bank makes payment by authorizing a debit to its reserve account at the Federal Reserve Bank. Repayment of borrowing, therefore, reduces both reserves and "borrowings from Federal Reserve Banks." See illustration 29. Unlike loans made under the seasonal and extended credit programs, adjustment credit loans to banks generally must be repaid within a short time since such loans are made primarily to cover needs created by temporary fluctuations in deposits and loans relative to usual patterns. Adjustments, such as sales of securities, made by some banks to "get out of the window" tend to transfer reserve shortages to other banks and may force these other banks to borrow, especially in periods of heavy credit demands. Even at times when the total volume of adjustment credit borrowing is rising, some individual banks are repaying loans while others are borrowing. In the aggregate, adjustment credit borrowing usually increases in periods of rising business activity when the public's demands for credit are rising more rapidly than nonborrowed reserves are being provided by System open market operations. Discount Window as a Tool of Monetary Policy Although reserve expansion through borrowing is initiated by banks, the amount of reserves that banks can acquire in this way ordinarily is limited by the Federal Reserve's administration of the discount window and by its control of the rate charged banks for adjustment credit loans - the discount rate.(17) Loans are made only for approved purposes, and other reasonably available sources of funds must have been fully used. Moreover, banks are discouraged from borrowing adjustment credit too frequently or for extended time periods. Raising the discount rate tends to restrain borrowing by increasing its cost relative to the cost of alternative sources of reserves. Discount window administration is an important adjunct to the other Federal Reserve tools of monetary policy. While the privilege of borrowing offers a "safety valve" to temporarily relieve severe strains on the reserve positions of individual banks, there is generally a strong incentive for a bank to repay borrowing before adding further to its loans and investments. 16Adjustment credit is short-term credit available to meet temporary needs for funds. Seasonal credit is available for longer periods to smaller institutions having regular seasonal needs for funds. Extended credit may be made available to an institution or group of institutions experiencing sustained liquidity pressures. The reserves provided through extended credit borrowing typically are offset by open market operations. back 17Flexible discount rates related to rates on money market sources of funds currently are charged for seasonal credit and for extended credit outstanding more than 30 days. back 26 A bank may incur a reserve deficiency if it makes loans when it has no excess reserves. back
27 Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a direct credit to the bank's reserve account. back
No further expansion can take place on the new reserves because they are all needed against the deposits created in (26). 28 Before a bank can repay borrowings, it must gain reserves from some other source. back
29 Repayment of borrowings from the Federal Reserve Bank reduces reserves. back
Changes in Reserve Requirements Thus far we have described transactions that affect the volume of bank reserves and the impact these transactions have upon the capacity of the banks to expand their assets and deposits. It is also possible to influence deposit expansion or contraction by changing the required minimum ratio of reserves to deposits. The authority to vary required reserve percentages for banks that were members of the Federal Reserve System (member banks) was first granted by Congress to the Federal Reserve Board of Governors in 1933. The ranges within which this authority can be exercised have been changed several times, most recently in the Monetary Control Act of 1980, which provided for the establishment of reserve requirements that apply uniformly to all depository institutions. The 1980 statute established the following limits: On transaction accounts first $25 million . . . . . . . . . 3% above $25 million . . . . . 8% to 14% On nonpersonal time deposits . . . . 0% to 9% The 1980 law initially set the requirement against transaction accounts over $25 million at 12 percent and that against nonpersonal time deposits at 3 percent. The initial $25 million "low reserve tranche" was indexed to change each year in line with 80 percent of the growth in transaction accounts at all depository institutions. (For example, the low reserve tranche was increased from $41.1 million for 1991 to $42.2 million for 1992.) In addition, reserve requirements can be imposed on certain nondeposit sources of funds, such as Eurocurrency liabilities.(18) (Initially the Board set a 3 percent requirement on Eurocurrency liabilities.) The Garn-St. Germain Act of 1982 modified these provisions somewhat by exempting from reserve requirements the first $2 million of total reservable liabilities at each depository institution. Similar to the low reserve tranche adjustment for transaction accounts, the $2 million "reservable liabilities exemption amount" was indexed to 80 percent of annual increases in total reservable liabilities. (For example, the exemption amount was increased from $3.4 million for 1991 to $3.6 million for 1992.) The Federal Reserve Board is authorized to change, at its discretion, the percentage requirements on transaction accounts above the low reserve tranche and on nonpersonal time deposits within the ranges indicated above. In addition, the Board may impose differing reserve requirements on nonpersonal time deposits based on the maturity of the deposit. (The Board initially imposed the 3 percent nonpersonal time deposit requirement only on such deposits with original maturities of under four years.) During the phase-in period, which ended in 1984 for most member banks and in 1987 for most nonmember institutions, requirements changed according to a predetermined schedule, without any action by the Federal Reserve Board. Apart from these legally prescribed changes, once the Monetary Control Act provisions were implemented in late 1980, the Board did not change any reserve requirement ratios until late 1990. (The original maturity break for requirements on nonpersonal time deposits was shortened several times, once in 1982, and twice in 1983, in connection with actions taken to deregulate rates paid on deposits.) In December 1990, the Board reduced reserve requirements against nonpersonal time deposits and Eurocurrency liabilities from 3 percent to zero. Effective in April 1992, the reserve requirement on transaction accounts above the low reserve tranche was lowered from 12 percent to 10 percent. When reserve requirements are lowered, a portion of banks' existing holdings of required reserves becomes excess reserves and may be loaned or invested. For example, with a requirement of 10 percent, $10 of reserves would be required to support $100 of deposits. See illustration 30. But a reduction in the legal requirement to 8 percent would tie up only $8, freeing $2 out of each $10 of reserves for use in creating additional bank credit and deposits. See illustration 31. An increase in reserve requirements, on the other hand, absorbs additional reserve funds, and banks which have no excess reserves must acquire reserves or reduce loans or investments to avoid a reserve deficiency. Thus an increase in the requirement from 10 percent to 12 percent would boost required reserves to $12 for each $100 of deposits. Assuming banks have no excess reserves, this would force them to liquidate assets until the reserve deficiency was eliminated, at which point deposits would be one-sixth less than before. See illustration 32. Reserve Requirements and Monetary Policy The power to change reserve requirements, like purchases and sales of securities by the Federal Reserve, is an instrument of monetary policy. Even a small change in requirements - say, one-half of one percentage point - can have a large and widespread impact. Other instruments of monetary policy have sometimes been used to cushion the initial impact of a reserve requirement change. Thus, the System may sell securities (or purchase less than otherwise would be appropriate) to absorb part of the reserves released by a cut in requirements. It should be noted that in addition to their initial impact on excess reserves, changes in requirements alter the expansion power of every reserve dollar. Thus, such changes affect the leverage of all subsequent increases or decreases in reserves from any source. For this reason, changes in the total volume of bank reserves actually held between points in time when requirements differ do not provide an accurate indication of the Federal Reserve's policy actions. Both reserve balances and vault cash are eligible to satisfy reserve requirements. To the extent some institutions normally hold vault cash to meet operating needs in amounts exceeding their required reserves, they are unlikely to be affected by any change in requirements. 18The 1980 statute also provides that "under extraordinary circumstances" reserve requirements can be imposed at any level on any liability of depository institutions for as long as six months; and, if essential for the conduct of monetary policy, supplemental requirements up to 4 percent of transaction accounts can be imposed. back 30 Under a 10 percent reserve requirement, $10 of reserves are needed to support each $100 of deposits. back
31 With a reduction in requirements from 10 percent to 8 percent, fewer reserves are required against the same volume of deposits so that excess reserves are created. These can be loaned or invested. back
There is no change in the total amount of reserves. 32 With an increase in requirements from 10 percent to 12 percent, more reserves are required against the same volume of deposits. The resulting deficiencies must be covered by liquidation of loans or investments... back
...because the total amount of bank reserves remains unchanged.
Modern Money Mechanics
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