Turmoil in the financial markets has resulted in more attention being given to the banking system. Many are familiar with the FRB data recently showing bank’s non-borrowed reserves dropping.
So, what about the reserve requirements for banks? A layperson would think that a bank has to keep a percentage of its total deposits as actual cash, actually available on demand. But these days it seems that’s an old-fashioned passe attitude. In actuality, banks are able to avoid the reserve requirements to an amazing extent. That way they can devote much more of your deposit accounts to suprime lending!
Curious exactly how its done? The FDIC (which is funded by the banks) published a study explaining it. Among other techniques, banks are using “sweeping” rules to decrease the amount of cash reserves they must actually hold. One bank “successfully” used sweeps to “reduce its required reserves from $788,000 in August 2000 to $48,000 in August 2001, a period when deposits at the institution rose by $36 million.”
“An additional impetus to establishing sweep accounts is the dollar amount required to meet a bank’s reserve requirements. All depository institutions must reserve an amount equal to between 3 percent and 10 percent of the funds they have in interest-bearing and noninterest-bearing checking accounts. The total required to be held in reserve is determined relative to the total deposits held in the qualifying accounts at each bank. Once the amount of the reserve is determined, banks may choose to hold their reserves in the form of cash (vault cash) or in an account at a Federal Reserve Bank (FRB) (sterile reserves), but in either case the funds are nonincome producing. As a result, a key strategy of bank liability management has been to discover ways of building a bank’s deposit base while keeping required reserves to a minimum.”
In the context of an ordinary checking or savings account (“retail demand deposit account”), the study explains the reserve requirement on these monies can actually be zero, and explains exactly how it works:
“. . . when newly designed computer software enabled a bank to analyze its depositors’ use of their transaction accounts, sweeps became one of the main tools used to minimize a bank’s required reserves: any funds deemed by the bank to be excess were automatically transferred into MMDAs. (As a result of these transfers, a bank’s required reserve ratio could go from 10 percent to zero). And in 1994, when the Federal Reserve Board authorized banks to use this software to reclassify any transaction-account, retail sweep programs developed as banks notified their customers when they opened an account that “your deposit may be reclassified for purposes of compliance with Federal Reserve Regulation D. . . .” Banks began initiating sweeps without the customers’ explicit approval, and the volume of transfers occurring between transaction accounts and MMDAs increased dramatically.
The MMDA used in a retail sweep program operates as a “shadow” account that is visible only to the depository institution. The bank reduces its required reserves while leaving unchanged the transaction deposits that are available to the depositor. A bank’s level of transaction accounts decreases sharply, whereas the depositor’s view of the account appears unaffected. Just as this transfer occurs without the depositor’s explicit approval or knowledge, so, too, any profits that the bank earns are not generally shared; in addition, banks also can choose how the funds will be invested.”
Bottom line: the bank may be operating a shadow account under your checking account, sweeping the money out, using it, and keeping the profits – and you’ll never know. Read the study here → fdicbankliability.pdf