Pledging Requirements and Bank Asset Portfolios

Under state and Federal law, commercial banks are required to hold government securities as a reserve against government deposits. While these pledging requirements are potentially important links between the asset and liability sides of a bank's portfolio, they have largely been ignored in the professional literature. This omission cannot be justified even if pledging requirements have no effect on bank demand for Government securities, because locking up Government securities as a pledge against public deposits forecloses their use as a source of bank liquidity and reduces flexibility in the management of bank assets. Moreover, if pledging requirements do have an impact on bank holdings of Government securities, fluctuations in the growth of government deposits will have important implications on the ability of banks to meet credit demands and on bank profitability. ' The purpose of this article is to examine the role of pledging requirements and to determine their impact on the asset portfolio of banks and on bank profitability. The first section of the article reviews the pledging requirements on both Federal and state and local government deposits, with particular emphasis on the requirements of the seven states in the Tenth District. In the second section, the arguments -both favorable and critical--concerning the role of pledging requirements are presented, and possible alternative procedures are discussed. The third section summarizes the empirical evidence on the effectiveness and likely consequences of pledging with regard to bank profitability and asset composition.