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Notes to myself, possibly of interest to others.
-- Bill Northlich

Monday, March 22, 2010

The new Fed: Doing away with the fraction in Fractional Reserve lending

"The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system."
---Ben Bernanke, "Federal Reserve's Exit Strategy", posted on federalreserve.gov, 2/10

As this spreads on the internet there is a lot of OMG being expressed, initially, by some in the blogosphere.  It was my first reaction.  But then the inevitable asserts itself:  Bernanke is neither dumb nor mad.  So why would he say such a thing.  Zerohedge has some info thereon.  Some quotes:

Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels....
 The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.
Zerohedge's ultimate take is that this is further evidence that the Fed is indeed crazy, as purported by Ron Paul, et. al. That is, what you thought were reserves are miniscule with respect to the total operational finances of a largish bank.

Crazieness of the Fed aside, Basel I and II focus on the capital ratios at banks, rather than Fractional Reserve Ratios, to calculate the overall financial health of banks.  Wikipedia has a nice writeup of this.

The Ciff Notes version, and what makes some sense to me, is that the leverage of a bank is the all-important figure.  It is defined by Basil I,II as the ratio of Tier 1 capital to risk-adjusted assets, or, very simply, as

       original capital invested in the bank plus retained earnings
                            Loans and investments

I understand this more immediately than the FR ratio.  I think the idea is that the FR ratio does not tell you much about what is going on in the bank, especially in this day of repos and securitization, but capital ratios do.

update:  Minimum reserve requirements are typically on the order of 10% of tier one capital, but there's no fixed amount.  IE, the leverage of a bank is much better understood by tier 1 to assets than by FR minimums.

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