Posted by: Dirk | December 24, 2015

Required reserves are an implicit tax on banks, says Fed

I have often talked to people who think that required reserves “work”. They believe that an increase in the ratio of required reserves (to deposits) will stop borrowing – or rather lending. That is not what seems to be happening, as lots of available evidence shows. Among others, there is a paper by Finn Körner and myself on Chinese monetary policy. We find that even though the required reserve ratio is varied over time, an increase does not mean that the quantity of bank loans stop growing. There is hence no easy way to connect required reserves to the quantity of bank loans. Instead, it is quite well-known that required reserves are a tax on the banking sector, since they used to get no interest for holding these reserves in a special account at the Fed. The US central bank now does pay an interest rate on required reserves. The Fed also writes on its website:

The interest rate on required reserves (IORR rate) is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions.

So, both theoretically and empirically there are sound arguments against using the required reserve ratio as a tool to influence the quantity of credit. Nevertheless, you can still use it as a tool to drain excess reserves and put a floor to your short-term interest rate. After all, nobody in the money market will be willing to lend at a rate below the deposit rate that is paid on both required and excess reserves.


  1. Sorry for the reply to an old article – I’m having trouble understanding why a reserve requirement is an implicit tax. Implicit because the bank isn’t allowed to just loan out 100% percent of their depositors cash? Would they even do that absent regulation? I thought keeping enough liquid cash to cover daily volatility and withdrawals was just a prudent and necessary part of the banking business. I guess I’m not understanding what opportunity is lost by keeping a sensible amount of reserves on hand, and why banks should be paid interest on their reserves for that lost opportunity.

    • The bank could park the reserves at the deposit facility, lend it out to ither banks or use it to buy an asset if there are no reserve requirements, as in the UK or Canada. Banks can borrow reserves against collateral if they need them. Why hoard reserves?

      • Interesting, didn’t know the UK, Canada etc. had no reserve requirement. Are there other bank regulations for minimum safe/liquid asset holdings in those cases? And does that discredit the whole money multiplier idea since commercial banks can essentially expand or contract the money supply infinitely as lending opportunities allow? Or does some other minimum holdings requirement keep that in check? Thanks for the reply and apologies if these are dumb questions – I’m not an economics major but curious about this stuff.

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