Is There Any Rationale for Reserve Requirements?

Reserve requirements have been part of the regulator)' apparatus of banking in the United States for more than a century and a half. No matter what their original purpose may have been, maintaining the burden of reserve requirements needs a contemporary rationale that can justify the problems they create. The problems attributed to reserve requirements are woven into the fabric of financial markets. The burden of meeting the regulation appears to vary unfairly among banks of comparable size. Financial institutions not subject to the regulation engage in many of the same activities as those required to hold reserves. Legislative efforts to overhaul the nation's banking and financial system would be easier if reserve requirements could be eliminated from the set of issues to be considered. Financial reform aside, reducing or eliminating these requirements might be a way to improve the profitability of banking and the willingness of banks to extend credit while under pressure to improve capital. Moreover, even if problem loan and inadequate capital matters were resolved, many analysts believe that reserve requirements still would impair the international competitiveness of U.S. banks. Two obvious approaches to removing the burden of reserve requirements are to eliminate them altogether or to pay a market rate of interest on reserve balances. This article deals only with the first approach, exploring various rationales for reserve requirements on the premise that there would be no point in paying a market rate of interest on reserves if there were no rationale for requiring reserves in the first place. Perhaps because the requirements have been part of the structure of depository institution markets for so long, their rationale seems obscure and the effect of their elimination even more so. Recent elimination of a portion of reserve requirements has sharpened the issue.' If a partial elimination was good, would not complete elimination be better? After a brief description of the reserve requirements now in place, the discussion is organized around their three traditional rationales: taxation,