The Demand for Excess Reserves.

• Author: Dow, James P., Jr.
• Position: Bank reserves - Statistical Data Included

James P. Dow, Jr. [*]

This paper provides an estimate of the demand for excess reserves in the United States. It finds that excess reserves are negatively related to the Federal funds rate and positively related to transactions deposits. It also finds that clearing needs significantly affect the demand for reserves with increases in excess reserves coming in response to lower required reserve balances and higher clearing volume. Some implications for monetary policy are discussed.

1. Introduction

   The demand for excess reserves is at the center of a number of issues in monetary economics. While at one time it was featured primarily in the calculation of money multipliers, more recently it has figured in Federal Reserve policy through its connection to the targeting of the Federal funds rate. Each week, the open market desk is obligated to forecast the demand for reserves, including the demand for excess reserves, to determine the amount of reserves to supply through open market operations. This shift in the role of excess reserves is reflected worldwide; a number of countries have abandoned reserve requirements altogether, and the entire connection between monetary policy and the economy is through the demand for "excess" reserves. This paper looks at recent data on excess reserves in the United States to determine the sensitivity of demand to changes in interest rates and other variables affecting the willingness to hold reserves.

   The standard approach to modeling the demand for excess reserves is to treat it as part of a bank's liquidity management decision. Banks want to hold reserves to avoid overdraft or reserve deficiency penalties on their account at the central bank when facing uncertain flows of funds. This general model of the precautionary demand for reserves was given by Poole (1968). Two basic propositions fall out of this approach. The first is that the quantity of excess reserves demanded should vary inversely with short-term interest rates, which are the opportunity cost of holding reserves, assuming that excess reserves pay no interest. The second proposition is that since excess reserves are providing a buffer against uncertainty about reserve balances, demand should increase with uncertainty. The textbook model of excess reserve demand assumes that this uncertainty increases proportionately with the level of transactions deposits. This paper finds support for both of these propositions. In recent years, excess reserv es have increased with the growth in transactions deposits and were negatively related to interest rates, decreasing roughly $120 million for each percentage-point increase in the Federal funds rate.

   The role of excess reserves in monetary policy depends on the particular operational strategy adopted by the central bank. The approach in the United States shifted in 1982, when the Federal Reserve moved to a borrowed reserve target from a policy of targeting the growth of nonborrowed reserves in response to the high variability of the Federal funds rate over the preceding years. [1] While some emphasis was still given to the monetary and reserve aggregates after that time, the implementation of policy effectively followed an interest rate targeting rule, although announcements of the intended Federal funds rate did not begin until 1994. The declared operating strategy of the open market desk ("the desk" henceforth) was to supply the amount of reserves demanded by banks less the borrowing target, relying on the fact that the demand for borrowing from the discount window was a relatively stable function of the difference between the intended Federal funds rate and the discount rate. This policy effectively t argeted the overnight interest rate since the only way to get the targeted amount of borrowing was by maintaining the appropriate spread between the Federal funds rate and the discount rate. The demand for excess reserves was believed to be relatively inelastic, and little attention was given to its response to changes in the intended Federal funds rate (e.g., Sellon and Seibert 1982).

   By the 1990s, the stable borrowing relationship had fallen apart (Clouse 1994), so interest rate targeting would have to rely on something else for interest elasticity in the Federal funds market. Because excess reserves pay no interest, banks are likely to economize on them when market interest rates increase, which might provide the necessary elasticity. Given a downward-sloping demand for reserves, setting the supply of reserves each day would fix that day's interest rate in the Federal funds market. Of course, required reserves may also be sensitive to changes in the interest rate; an increase in opportunity cost may cause a shift out of non-interest-bearing deposits, producing a corresponding decline in required reserves. However, this is likely to be a slow process and thus difficult to use as the basis for short-term interest rate targeting. It is the demand for excess reserves that provides the short-term interest rate elasticity relied on by the desk.

   This downward-sloping demand for excess reserves is the conceptual basis of interest rate targeting in the absence of reserve requirements (e.g., Longworth 1989; Sellon and Weiner 1996). A number of countries have already moved to monetary systems without reserve requirements so that their demand for reserves is entirely a demand for "excess" reserves (Borio 1997). The United States is also moving in that direction, although not for any reason of policy. Commercial banks have implemented "retail sweep programs," which have dramatically reduced the level of deposits subject to reserve requirements (Edwards 1997). As the level of required reserve balances has fallen, the risk of overdrafts at banks' accounts at the Federal Reserve has increased. Because of this, the demand for excess reserves is starting to have less to do with reserve requirements and more to do with the desire to avoid overdrafts. The latter demand, known as a clearing demand or payments-related demand, is now one of the central features of the Federal funds market. Indeed, some banks are no longer bound by reserve requirements and hold deposits at the Federal Reserve only because of clearing needs (Edwards 1997). It is thought that the lower level of required reserve balances and the increased risk of overdrafts might result in increased volatility of the Federal funds rate (Clouse and Elmendorf 1997) and an increased demand for excess reserves. This paper finds some support for an inverse relationship between required reserve balances and excess reserves, although the effect is small. Part of the reason for the small response may be the additional margin for adjustment provided by required clearing balances, which is examined in section 4 of this paper.

   The policy of targeting the interest rate on a day-to-day basis requires high-frequency estimates of the demand for excess reserves in order to guide the actions of the desk. Each week the staff at the Board of Governors of the Federal Reserve and the New York Federal Reserve Bank make forecasts of this demand. The estimate will depend on persistent factors, such as the level of transactions deposits or interest rates, but also on short-run factors that affect clearing demand. This paper reports the desk's response to several of these factors.

   Estimating the demand for excess reserves is complicated by the fact that what is observed is not the demand but the quantity of excess reserves supplied, which is determined primarily by the actions of the desk. This is simplified somewhat by the current operational policy of the desk, which is to supply the level of reserves demanded at the targeted Federal funds rate. Since the supply function is trying to mimic any changes in demand, we can use estimates of supply to infer changes in demand. The ability to get accurate estimates this way depends on how well the desk does in matching shifts in demand. Overall, the effective Federal funds rate is close to the intended rate, suggesting that the desk does well in meeting its target, making this an effective way to estimate excess reserve demand. However, the information from interest rate deviations can also be used to improve the desk's performance, particularly in reacting to changes in clearing needs. In the future, there will probably be an increasing ne ed to use interest rate information of the kind presented in this paper to guide policy.

2. The Demand and Supply of Excess Reserves

   Banks hold balances at the Federal Reserve for two purposes: to meet reserve requirements and to facilitate transactions that require the transfer of Federal funds. For purposes of meeting reserve requirements, the level of reserves are calculated as the average amount held over a 14-day "maintenance period" (Meulendyke 1998). Excess reserves refer to balances held at the Federal Reserve above the required amount and are used to buffer against unexpected fluctuations in reserve balances or required reserves since there are substantial penalties to not meeting reserve requirements. [2] The demand for excess reserves is primarily a "14-day" or maintenance period concept since reserves held on one day are perfect substitutes for reserves held on other days of the period in terms of meeting reserve requirements. However, banks with accounts at the Federal Reserve are also required to have nonnegative levels of balances each day, or else pay an overdraft penalty. Because of this, additional balances held on one d ay do not provide protection against overdrafts on future days, making balances imperfect substitutes across days.

   The basic model of a precautionary demand for excess reserves, where banks hold extra reserves as a precaution against fluctuations in reserves or reserve requirements, was developed in Poole (1968). This approach has been used recently in the discussion of the demand for clearing balances in the context of both...