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would also help to fulfill the
regulatory requirement. In addition to inducing banks to hold
more vault cash than they otherwise would, reserve
requirements reduce the sensitivity of these inventories to
market interest rates. When a bank’s demand for vault cash is
effectively decided by reserve requirements, rather than by
inventory cost-benefit considerations, market interest rates
become less directly relevant.5
Bank Balances in Federal Reserve Accounts
Similar logic applies to the balances that banks hold in their
Federal Reserve accounts. Banks use these accounts to provide
check clearing and electronic payments services, including the
sending and receiving of funds over the Federal Reserve’s wire
transfer system for the settlement of their customers’
commercial and financial transactions. Banks are required to
avoid negative end-of-day balances in these accounts. Given
the uncertain timing and size of customers’ payments, banks
tend to leave themselves a margin of error. They do this by
aiming for an end-of-day balance big enough to minimize their
risk of being overdrawn. To manage the levels of these balances,
banks purchase or sell funds in their own names in the federal
funds market.
The Federal Reserve is not allowed to pay interest on these
account balances. However, in order to create a competitive
parallel to banks offering correspondent services, the Fed offers
“clearing balance” arrangements. Although these areI. Introduction
he Federal Reserve requires U.S. commercial banks and
other depository institutions to hold a minimum level of
reserves in proportion to certain liabilities. On occasion, the
central bank has reduced reserve requirements—such as in
1990, when requirements on large time deposits were dropped,
and in 1992, when requirements on transaction accounts were
reduced. In addition, more and more banks since 1994 have
used computer technologies that temporarily “sweep” deposits
from one type of account to another, thereby reducing required
reserve levels.
To provide customers with payments-related services,
banks hold assets in two forms that also qualify as reserves:
vault cash and balances deposited in Federal Reserve accounts.
Such assets earn no interest when they meet reserve
requirements, and traditionally the requirements have led
banks to hold greater amounts of these nonearning assets than
were optimal for business purposes. Reserve requirement
reductions and deposit sweeping have allowed banks to lower
such incremental costs.1
After the elimination of reserve requirements on
nonpersonal time deposits and eurocurrency liabilities in 1990,
the federal funds market experienced a significant surge in
volatility. This occurrence, coupled with the growth in retail
sweeps in the late 1990s, has raised concerns that the continued
decline in reserve balances would again destabilize the federal
funds rate, thereby increasing the financing costs of borrowing
banks and dealers. Despite the sharp drop in reserve balances,
however, the effect on the overnight markets has been
negligible, because at the same time banks have increased their
reliance on Federal Reserve clearing balances and implemented
more sophisticated information technologies (Clouse and
Elmendorf 1997; Bennett and Hilton 1997). Banks “unbound”
by reserve requirements ar