Regulations D, Q, and modern monetary policy

This long post will discuss Regulations D and Q, their history, purpose and effect on the banking
system. It elaborates on modern monetary policy operations and recent developments that have
further removed the necessity for the anachronistic reserve requirements established in Regulation
D.
Regulations D and Q were written to clearly demarcate between highly liquid transaction accounts
and less liquid savings accounts/ bank CDs. Their purpose was only relevant under the gold
standard. Under the gold standard, demand deposits (checking account deposits and physical
currency) could be exchanged for gold at a fixed rate, whereas time deposits (savings
accounts/CDs) could not.

Therefore the banking system needed to control the flow between the percentage of the money
supply that was not convertible into gold (savings/CDs/bonds) and that which was
(checking/cash). Reg Q’s purpose was to allow banks only to pay interest on non-convertible time
deposits as a way to incentivize customers to put their deposits into these accounts, and therefore
limit the banking system’s exposure to gold convertibility risk. To further delineate time and
demand accounts, Reg Q also prohibited the payment of interest on demand deposits until 2011.

Regulation D then, required banks to hold a certain percentage of central bank money (reserves or
vault cash) against certain types of deposits. The classes of reservable deposits has changed over
time, and now only net transaction accounts, (demand deposits/checking accounts) must be
reserved against:

As an another matter, Reg Q also capped the interest rate that banks could pay on savings deposits,
in order to prevent banks from “reaching for yield” (competing for lower quality (more expensive)
loans which would then have been used to fund the higher rate paid to depositors. Another
objective of capping interest rates on deposits was to increase bank profits by limiting the
competition for deposits. Congress at the time felt that competition for deposits not only reduced
bank profits by raising interest expenses, but also have might cause banks to acquire riskier assets
with higher expected returns in attempts to limit the erosion of their profits.

Congress thought unpredictable movements of deposits among banking institutions in response to

interest rate competition made some banks vulnerable to failure. Another related reason was that
big money center banks could pay higher interest rates for deposits than smaller banks, and thus
could bid deposits away from smaller regional banks. Larger banks frequently made more
speculative loans, such as for buying shares in the stock market. Lawmakers believed that this
competition for deposits misallocated financial resources away from productive to speculative uses.

In this way, Reg Q set a rough floor to lending quality. Reg Q’s blunt way of preventing the “race to
the bottom of underwriting quality” has now largely been replaced by ability-to-repay standards
from CFPB, and the capital regulation system established by the Basel negotiations that began in
1988.

Regulation D is written to limit the liquidity of savings accounts by only allowing a certain amount
of monthly withdrawals from time to demand accounts. Reg D also imposes reserve requirements
on depository institutions, which was intended as a tool for managing the supply and price of bank
money. These requirements created a continuous demand for central bank money (reserves) above
and beyond what was needed for interbank payment settlement. Therefore by creating demand, the
Fed as the monopoly supplier of reserves could control the price of these reserves and therefore the
profitability of bank lending.

Before 1971 when the Federal Reserve’s own liabilities were convertible to gold, it had an incentive
to restrict the amount of its reserves that backed the credit created by the banking system. So once
this gold convertibility ended, the Fed slowly began to ease its reserve lending facilities, since it no
longer faced any convertibility risk of its own. The 2003 amendments to Regulation A, which
established the discount window Primary Credit Facility as a “no questions asked” liquidity facility
were perhaps the first demonstration of this change.

Technically however, the US left the gold standard in 1933, with only dollars in foreign central
banks convertible into gold during the Bretton Woods era which ended in 1971. Nevertheless,
during this time and to some degree up to the present, the Federal Reserve and economics
profession have not fully understood the monetary policy implications of the removal of the gold
constraint.

Since the Fed both imposes reserve requirements, and requires a positive end of day balance in all
Fedwire accounts, it has no choice to provide reserves to the banking system, at its target rate.
These reserves can be provided through open market operations/Repos, through intraday credit
through the Daylight Overdraft facility, or finally through the discount window at a penalty rate.
The demand for these reserves is completely inelastic, much like a diver at the bottom of the ocean
needs an air supply. Not providing reserves at any price would result in either a shortage of clearing
balances or shortage of required reserves, both of which would cause banks to bid up federal funds
above the FOMC’s target rate. Therefore, the Fed as the monopolist, has no choice but to provide
reserves in unlimited quantities at its target rate in order to defend the payment system and ensure
all reserve requirements can be met without bidding up the federal funds rate.

If banks were left on their own to obtain more reserves no amount of interbank lending would be
able to create the necessary reserves. Interbank lending changes the location of the reserves but the
amount of reserves in the entire banking system remains the same. For example, suppose the total
reserve requirement for the banking system was $60 billion at the close of business today but only
$55 billion of reserves were held by the entire banking system. Unless the Fed provides the
additional $5 billion in reserves through some facility, at least one bank will fail to meet its reserve
requirement. The Federal Reserve is, and can only be, the follower, not the leader when it adjusts
reserve balances in the banking system. Perhaps the best example of the irrelevancy of reserve
requirements is that the Fed has not changed them since April 1992, the month when I was born!
However, it is important to keep in mind that the reserve requirement itself does not matter. If
reserve requirements are 10% or 100%, either way the Fed must provide reserves at its target rate,
as explained above.

Once Richard Nixon ended what was left of the gold standard in 1971, neither of the restrictions
from Regulations D or Q became necessary. Since neither demand nor time deposits were
convertible to gold (or anything else at a fixed rate) after 1971, the banking system faced no
convertibility risk and therefore did not need to differentiate between deposit accounts or pay
interest on time deposits to reduce such risk. Other than issues relating to funding stability, from
the banks perspective checking and savings accounts became essentially the same. The regulatory
atmosphere finally caught up to this post-gold standard reality in 2011 when the Federal Reserve
repealed the last remaining part of Reg Q which prevented banks from paying interest on demand
deposits (see side note).

While Reg D still exists, it is also less relevant than ever. The movement of much of the deposit base
to money market mutual funds, and allowing banks pay interest on both checking and money
market accounts, makes Reg D’s limit on time deposit withdrawals largely irrelevant. Further, over
the past several decades most banks have become able to effectively avoid reserves requirements
through the use of sweep accounts. These sweep accounts are set up to automatically sweep most
of a banks reservable deposits (demand) into non-reservable deposits (time) at the end of each 14-
day reserve maintenance period, which reduces most of a banks reservable deposits.

Sweeps surged between 1995 and 2000. All charts from the Federal Reserve.

The proliferation of sweep accounts has significantly reduced the percentage of banks required to
maintain reserve balances.
Many depository institutions seek to meet most of their reserve requirements through holding
vault cash. Since vault cash is necessary for the everyday business of meeting ATM/window
withdrawals, banks figure they might as well use cash to meet reserve requirements as well. So
what banks do (or at least did before IOR) is to meet as much of the reserve requirement through
vault cash, and then adjust their reservable deposits so the RR would be met by what they already had
in cash. This is the opposite of what the old fashioned, textbook version of reserve requirements
would suggest.
Required reserve balances declined sharply in the 1990s as vault cash holdings rose.

Further, the trillions of excess reserves in the banking system resulting from three rounds of
quantitative easing have left the banking system with enough reserves to meet even these minimal
requirements for decades into the future. Much of the Federal Reserve’s own literature has
supported both of these points.
All of this all dramatically changed during the financial crisis of 2008. As the financial crisis was
worsening the Fed faced a conundrum. Through its various new/expanded crisis- lending facilities
(discount window, TALF, Corporate paper facility, etc), the Fed was adding trillions of dollars of
reserves to the banking system, but it still had an overnight interest rate target above zero. Having
run out of unencumbered Treasury securities to sell off its portfolio in order to drain these added
reserves and support its interest rate target, the Fed needed a new tool (during this time the Fed
actually had to rely on Treasury to conduct a special purpose bond offering with the sole purpose of
draining reserves, known as the Special Financing Program or SFP).

The Financial Services Regulatory Relief Act of 2006 had authorized the Federal Reserve Banks to
pay interest on balances held by or on behalf of depository institutions at Reserve Banks, subject to
a rulemaking by the Board of Governors, to be effective October 1, 2011. The effective date of this
authority was advanced to October 1, 2008 by the Emergency Economic Stabilization Act of 2008,
and a rule amending Regulation D was finalized just a week later.

So in October of 2008 the Fed gained the ability to pay interest on reserve balances, a power which
it previously did not have. This allowed the Fed to establish a non-zero overnight interest rate
without having to conduct any POMOs or Repos. With the floor of interest rates now solidly in place,
the Fed could continuing lending emergency reserves into the banking system while simultaneously
maintaining a nonzero federal funds rate. Interest on Reserves (IOR) changed the game in the
federal funds market, and trading volume decreased significantly, by about 75%.

The 2008 changes to Regulation D effectively eliminated the need for reserve requirements. Since
the Fed now has the ability to pay interest on reserve balances, it can “sterilize” a certain
percentage of the monetary base simply by incentivizing banks to move balances out of the federal
funds market and into interest bearing reserve accounts, known as “excess balances accounts”. It
can also do this in a more limited fashion with its new Term Deposit Facility (neither of these
facilities are available to the GSEs or FHLBs, so some trading in federal funds remains, which is why
the effective federal funds rate is slightly below the 25 basis points paid on reserves). In this way,
the rate paid on reserve balances serves as a floor to short term interest rates, and the rate charged
for institutions that borrow reserves from the Discount Window or through overdrafts represents a
ceiling on short term rates.
So with this monetary incentive in place, there is no need to require banks to hold a certain amount
of reserves through regulation. Under the IOR system, no regulatory requirement is needed to
create a demand for reserves (although even with no IOR banks would still need to hold reserves to
meet payments).

This is the way the Bank of Canada has implemented monetary policy since 1999. Canada
eliminated its reserve requirements in the 1990’s. Since then, it has set a floor for the overnight rate
through the interest it pays on settlement (reserve) balances, known as Deposit Rate, and set the
ceiling through the rate it charges for overnight loans (discount window), known as Bank Rate.
Deposit rate and Bank rate are usually set 50 basis points apart, just like the IOR rate and Discount
rate are in the US. The overnight rate therefore trades in the band between these two rates, and the
Bank of Canada sets the midpoint of these two rates as its target rate. This can be expressed as:
Bank Rate>Target Rate>Deposit Rate.

Concerns that implementing monetary policy by increasing the rate paid on reserves represent an
increased cost to the government are unfounded. While it is true that the interest the Fed pays on
reserves is subtracted from what it would otherwise remit to the Treasury, the Treasury ends up
‘paying’ either way. If the Fed were to raise interest rates by selling off part of its Treasury portfolio,
as it has done in the past, then its earnings, and therefore remittances to the Treasury, would
decrease by about the same amount, and the yield on new Treasury offerings would rise. (In fact, it
is likely the case that banks end up earning less under the IOR scenario, since the spread earned by
Primary Dealers banks acting as middlemen between Fed and Treasury operations was likely
higher than the current 25 basis points paid on all reserve balances). Therefore the size of the Fed’s
payments to the Treasury depend on the size of its portfolio, not on the method used to raise
interest rates. Either way, the Federal Reserve’s earnings represent a tax on the economy, since the
dollars that it earns and remits to the Treasury would have otherwise remained in the economy and
distributed to savers, bondholders, or bank shareholders.

QE merely represent a swap of governmental assets. When the FRBNY purchases Treasury and
Agency securities, is removes the Treasury/agency liability and replaces it with its own liability
(reserves). Deposits merely shift from securities accounts at the Fed (saving) to reserve accounts at
the Fed (checking). This is identical to moving money from a savings account to a checking account.
Concerns that this rise in reserve balances could lead to inflation stem from a misunderstanding of
the post gold standard banking system. Since the start of QE, many lawmakers and banking analysts
have express concern that this increase in reserves will lead to an explosion in new money creation
through bank lending ,that could put upward pressure on prices (needless to say, these people have
been completely wrong.) However, even before QE, as described above, the Fed, as the monopolist
of reserves, had no choice but to provide reserves to the banking system in unlimited quantities, at
its target rate. Now, as before, the Fed can only influence the marginal cost/profitability of making a
loan, not a bank’s ability to do so. Bank lending is not constrained by any quantity of reserves; it is
the price of reserves that influence the marginal cost of making a loan.
When banks make loans, they are not “loaning out reserves” as is often portrayed. Reserves are
simply a liability of the central bank that can only exist in central banks accounts, known as reserve
accounts. Reserves cannot be lent “out”, or leave the banking system (except as withdrawals of
physical currency, which is not a matter of monetary policy). In reality, banks create credit, which
Reg D then requires to be backed by a certain amount of central bank money; they do not “lend out”
anything. The textbook money multiplier model only applies to countries on a fixed exchange
rate where the central bank itself faces a convertibility risk. In most countries with floating
currencies, the money multiplier model does not apply, as the Bank of England demonstrated in
this paper and video last year. Most of these countries have appropriately eliminated reserve
requirements after recognizing that they are no longer necessary.

During the “bubble” of the 2000’s when ostensibly too much lending was going on, there were only
a few billion of excess reserves in the banking system. Now with $2.5 trillion of excess reserves,
there is arguably “not enough” lending going on. Clearly there is no correlation between quantity of
reserves and lending. It’s about marginal price, not quantity.

Bank lending merely represents the creation of a new demand deposit balance for the borrower
(the banks liability) and a corresponding creation of a new bank asset of equal value (the
borrower’s liability). This is accomplished through simple dual-entry accounting, and done
completely independently of a bank’s reserve position. Loan officers do not have to check with the
CFO to see if they “have the money” to make a loan! Once the borrower pays back the loan, both the
bank’s liability and the bank’s asset cease to exist, wiping out both sides of the balance sheet.
Therefore, eliminating Regulation D’s reserve requirements (as was done in Canada many years
ago) will have no tangible effect on bank lending, economic growth, or inflation.
In any case, the Federal Reserve cannot control the money supply, as the failed efforts of the
monetarists in previous decades has demonstrated. The money multiplier is simply the ratio of the
broad money supply to the monetary base (mm = M/MB). Changes in the money supply cause
changes in the monetary base, not vice versa. The money multiplier is more accurately thought of as
a divisor (MB = M/mm). Failure to recognize the fallacy of the money-multiplier model has led even
some of the most well- respected experts astray. The inelastic nature of the demand for bank
reserves leaves the Fed no control over the quantity of money. The Fed controls only the
price,which has not been changed by QE or IOR, and would not be changed by eliminating reserve
requirements.
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Side note: now that banks are allowed to pay interest on checking deposits, theory indicates that
checking account balances at banks would rise, since they no longer represent a lost interest
opportunity to the depositor. However, an increase in checking account balances also means an
increase in demand deposits, which banks have to hold reserves against. Normally, an increase in
reservable deposits (in absence of sweeps of course) would constitute a larger “tax” on the bank,
since holding more unremunerated reserves would impose a marginal cost to the bank. However,
now that the Fed pays interest on both required and excess reserves, the higher cost of holding
more reserves against larger checking account balances can be mitigated.