Jeremy Stein wrote an interesting FT editorial on reserve requirements as a win-win solution to solving the large Fed balance sheet from QE purchases. It is an interesting proposal and could be a simple way out from selling all of their Treasury holding.
You may remember reserve requirements. It is the central bank policy that every economic student is taught in their intro course on banking. Fractional banking is how money will be expanded in an economy. Changing the reserve requirement will have a direct impact on the size of money in the economy. A reduction in the reserve requirement means that banks can issue more new demand deposits. An increase in reserve requirements will cause shrinking of the money supply. Of course, the Fed does not use reserve requirements anymore to make their monetary decisions. It has been viewed as too blunt an instrument relative to change rates. But, we do not change rates anymore because we are in a zero rate environment. We have moved to QE, so reserve requirements may not be so blunt a policy tool as before.
Stein believes that this could be a simple way to solve the current banking problem of the large balance sheet. Go back to old school monetary policy. Right now there is a significant amount of excess reserves held at banks. These can be reduced through increasing the reserve requirement while still offering interest payments to the banks. An increase in reserve requirements will rescue the amount of money that can circulate in the economy. It would be the same as selling some of its balance sheet. Problem one of excess money can be solved.
Problem two for banks is that they need to have more capital. Reserve requirements may serve as a substitute for bank capital. It is a ready source of funds that can meet the needs of banks instead of Basel III requirements. It si a nice bank cushion.
Reserve requirement adjustments are a win-win for bank capital management and for fed policy.
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