Examining the Nature of Reserves Dispels 2 Misconceptions

By Staats, William F. | American Banker, September 20, 1985 | Go to article overview

Examining the Nature of Reserves Dispels 2 Misconceptions


Staats, William F., American Banker


SOME SEGMENTS of the banking industry oppose certain elements of the administration's proposed tax reform legislation. One of the arguments bank lobbyists put forth goes like this: Banks receive no interest on the reserves they must hold, and the Fed invests those reserves, turning most of the interest earned back to the U.S. Treasury. Therefore, banks pay an effective tax in the form of lost earnings.

That view of bank reserves and Federal Reserve investments is consistent with the understanding (or lack thereof) behind a bank-supported proposal to require the Federal Reserve to pay interest to banks on required reserves. Some time ago, the American Bankers Association's bank directors briefing discussed that proposal as follows: "The Fed would be allowed to pay interest on required reserves, rather than turning the net earnings on such reserves over to the U.S. Treasury."

Whatever the merits or deficiencies of such arguments, we should be clear about the central issue. There seems to be a misconception abroad in the land that the Federal Reserve System acquires the reserves of financial institutions and then uses those reserves to purchase government securities upon which the Fed draws interest. That incorrect view of what happens involves two misconceptions.

First, there is the implication that the Federal Reserve buys government securities simply because it has the "cash" deposited by banks in their reserve accounts at the central bank.

Commercial bankers can be forgiven for thinking that way for, after all, that is how things work at a depository institution. However, the Federal Reserve has a motivation other than to employ deposits in an earning asset. Rather than using reserves to buy government securities, the Fed buys securities in order to create bank reserves that, in turn, enable banks to create money (deposit liabilities) through lending and investing activities.

The extent to which banks can create money depends upon their reserve position, and it is that reserve position which the Federal Reserve affects by its purchases of government securities. …

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