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Tuesday, March 23, 2010 11:11 AM

Bernanke Wants to End Bank Reserve Requirements Completely: Does it Matter? What Chaos will Result?

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Many people have written over the past few days asking me to comment on the very last sentence in Chairman Ben Bernanke's speech on the Federal Reserve's Exit Strategy before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C.

"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."

There has been a lot of discussion over this line in various places such as on Yahoo Finance: Bernanke Wants to Eliminate Reserve Requirements Completely

If there were no minimum reserve requirements, what kind of chaos would that lead to in our financial system? Not that we are operating with sound money now, but is the solution to have no restrictions at all? Of course not.

What in the world is Bernanke thinking?
The same article appeared on Economic Collapse: Money Out Of Thin Air: Now Federal Reserve Chairman Ben Bernanke Wants To Eliminate Reserve Requirements Completely?

Does This Matter?

This is going to shock every hyperinflationist in town (and perhaps every inflationist and deflationist too) but amazingly, elimination of bank reserve requirement is essentially meaningless.

All Bernanke is doing is making a proposal to change the official policy so that it matches the current state of affairs. In simple terms, the proposal will change nothing.

Current State Of Affairs Review

There are no reserve requirements on savings accounts right now. So in regards to a savings account question: What has changed? The answer is "Nothing".

There are reserve requirements on checking accounts, but you have to take into consideration the fact that Greenspan allowed sweeps in 1994.

Sweeps allow banks to move (sweep) money from checking accounts into savings instruments nightly (unbeknown to customers who think the money is really there in their checking accounts). As I have pointed out many times already, the money is simply not there.

Once Greenspan allowed banks to sweep, banks did so in mass, and the end result is there are essentially no reserve requirements on checking accounts either.

The bottom lines is banks will continue to do what they have done since 1994, and that is to keep enough reserves on hand to meet estimated withdrawals. So in regards to checking accounts: What has changed? The answer once again is "Nothing".

In essence, all the Bernanke proposal does is eliminate the need for banks to sweep and to keep an accounting of those sweeps.

Fictional Reserve Lending Reviewed

Once again I invite everyone to read Fictional Reserve Lending And The Myth Of Excess Reserves.

The numbers below are out of date but the example still applies. Here is the relevant section from the above link:
3: Bank reserves are "Fictional", there are essentially no reserves at all.

To see if we can prove this statement we can look at total lending vs. base money supply and M2.

Karl Denninger at Market Ticker has a nice chart of total lending based on Federal Reserve Z.1 Flow of Funds data.

Cumulative Debt

click on chart for sharper image

Base Money Supply

Note the rampant increase in base money which is the source of those so-called excess reserves.

Let's do a little math.

There is 2,000 billion base money.
There is 52,000 billion lending.
The ratio of base money to lending is 3.8%

Prior to the ramp in base money (which by the way was the Fed's feeble attempt to supply reserves after the fact), there was $800 billion base money supporting $52,000 billion in lending. Not too long ago, the ratio of base money to lending was a mere 1.5%.
At the time that was written there was $2 Trillion in base money and $52 trillion in lending. With those ratios it is ridiculous to talk of "reserves" as if they exist. The only reserves banks keep are what they deem necessary to meet short-to-mid-term liquidity needs to cover withdrawals.

Please read the rest of the article if you have not done so because it debunks the idea that excess reserves will make their way into the market causing huge inflation. The system does not work that way. In practice, lending comes first and the Fed provides what little reserves are needed, after the fact to cover it.

Now the Fed is saying no reserves are needed. That will not really change anything because banks will keep enough on hand to meet their estimates of liquidity requirements just as they already do.

Two Questions Answered

Market Ticker asked a few questions. Let's recap two of them.

Q1: What in the world is Bernanke thinking?

A1: That elimination of reserve requirements simply matches what banks are already doing. Moreover, a formal policy shift eliminates a bunch of accounting paperwork that started in 1994 when Greenspan authorized sweeps.

Why makes banks go through all these sweep charades given the result before and after is effectively a policy of "no reserves" anyway? Viewed that way, (and at the risk people will take this sentence completely out of context) Bernanke's proposal makes perfect sense.

Q2: If there were no minimum reserve requirements, what kind of chaos would that lead to in our financial system?

A2: Exactly the kind of banking chaos we have already seen! Nothing has changed. Expect more chaos because it is coming.

Mike "Mish" Shedlock
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