The importance of "reserve requirements"

One of the central pillars of bank regulation is capital and reserve requirements. The Basel III regulation advocates larger capital adequacy, higher quality of capital, and more liquidity requirements, though critics argue that they are too small to be effective in cushioning banks against financial crises.

Traditionally, micro-prudential regulation of banks has sought to align their incentives against excessive risk taking and also reduce vulnerability to bank runs using minimum equity capital standards and reserve requirements respectively. However, while the former, however inadequate its magnitude, remains an important instrument of banking regulation, the latter appears to have become marginal in many developed countries.

Reserve requirements consist of both cash and liquid government securities, the former being reflected in cash reserve requirements and the latter in liquidity ratios. In the US and many developed countries, on grounds that they adversely affect bank profitability, both these are no longer important levers of bank regulation. Banks have lobbied strongly, arguing that such requirement adversely affect their profitability, and have managed to convince regulators to rely on publicly provided instruments like deposit insurance as hedge against bank runs. However, in developing countries, they remain critical tools for the bank regulators to cushion the system against bank runs.

In the context of the global financial crisis and the policy measures undertaken to mitigate the credit squeeze, bank reserve requirements assume great significance. A minimum bank reserve requirement, with a counter-cyclically adjusting split between cash and securities, would have enabled bank regulators considerable flexibility in managing the crisis. The important point here is that the reserves would include both cash and government securities, and their respective shares would be dynamic.

In good times, a higher share of cash would serve to throw sand on the wheels of a galloping financial market. Further, by keeping the share of government securities low, it would also ensure that governments do not convert the reserve requirement as a backdoor to support public borrowing. This is a very valid concern, since the RBI in India effectively uses the statutory liquidity ratio (SLR) to force banks to buy government debt. A single reserve requirement, with cyclically adjusting shares of cash and securities, would help eliminate this discretionary risk. The higher share of cash would also be useful in a crisis - it provides a more reliable (than capital ratios) signal against default risk besides also providing a high enough base which can be lowered to increase liquidity in the system.

In contrast, in times of liquidity squeeze, a higher share of securities would have freed up more liquidity and also made banks increase their share of securities holdings, which in turn would have contributed to increasing the price and lowering the yields of these securities. In other words, these actions would have had the same effect as the quantitative easing programs of central banks. In India, the presence of SLR and cash reserve ratio (CRR) have enabled the RBI to indirectly carry out quantitative easing to ease liquidity squeeze in recent years.

Furthermore, as Jeremy Siegel and Charles Calomiris have written, an increased use of reserve requirements would provide the US Fed with a very effective tool to manage a calibrated exit from the extraordinary balance sheet expansion of the last five years.

Along with other prudential regulations, Charles Calomiris has suggested a 20% cash reserve requirement for banks. Though the magnitude will be a matter of debate, the case for using reserve requirements in banking regulation is compelling.