Asset-based reserve requirements

Asset-based reserve requirements (ABRRs) are regulatory-framework policy proposals requiring financial institutions (FIs) to keep central bank reserves against their diverse asset class holdings. Conceptually, ABRRs are set by the monetary (or regulatory) authority and vary depending on the risk perceptions associated with each asset class. Technically a tax on financial intermediation, ABRRs are most effective if applied system-wide for all FIs.

Given their flexibility, ABRRs have a strong policy appeal in times of financial dis- tress or excessive growth in any particular asset class (for instance, subprime mortgages). Properly structured, ABRRs should help contain asset price inflation with strong micro- economic and macroeconomic potential.

Palley (2000, 2003, 2004, 2007) has popularized ABRRs most vocally, with addi- tional analysis provided by D'Arista (2009), although there has been some criticism (see for instance Toporowski, 2007). Methodologically, ABRRs imply a directly opposite regulation of FIs' central bank reserves. With ABRRs, the FIs hold non-interest-bearing deposits with the monetary authority as reserves based on the FIs' asset holdings. This differs from liability-based reserve requirements (LBRRs) which are common today with a typical deposit-driven required reserve ratio.

Therefore, for FIs, the ABRRs structure results in a real cost of forgone potential earn- ings on a particular asset (mortgage loans, equity holdings, and so on) owing to higher reserve requirements. FIs are then forced to reallocate larger funds to comply with the regulation. Facing lower returns, FIs are expected to reduce their holdings of the riskier asset and diversify into other asset categories with perhaps lower reserve requirements.

One immediate concern with the implementation of ABRRs is the lack of detailed accurate information about FIs' balance sheets, as transactions with multiple asset types vary substantially across FIs and markets. Toporowski (2007) also points to policy ineffectiveness, owing to FIs' excess reserves holdings. Though a valid concern, the global financial crisis of 2008-09 has shown that excess reserves are typical of a profit- maximizing firm. With cash acting as a raw material as well as an asset, it is expected that during relatively stable economic periods, FIs will extend loans and invest in interest- bearing assets, while keeping the reserves to a regulatory minimum. In times of economic distress, the opposite would hold, as evidenced by the unprecedented high excess reserves holdings in the US banking system (at the time of writing in 2014).

Conceptually, then, ABRRs serve several purposes as implicit automatic stabilizers. Varying by asset category, ABRRs allow the monetary authority to impose restraints on certain types of financial activity without raising general interest rates. Hence subprime mortgage lending could be discouraged by raising the costs for FIs via higher reserve requirements associated with such loans, without having a direct impact on investment loans and healthy economic growth. As asset values fall, ABRRs generate monetary easing effects, releasing previously held reserves. This mechanism also allows scaling a rapidly expanding financial system for example, offering more flexibility in restraining bubble-like scenarios.

At a microeconomic level, ABRRs may be used to allocate funds for public purposes in infrastructure and elsewhere. This could be encouraged by monetary authorities setting lower reserve requirements on such types of loans and investment projects. Critically, in the current post-crisis framework, ABRRs could be a useful tool as central banks scale back their quantitative easing programmes. A gradual increase in ABRRs leads to a reverse quantitative easing that ensures a smooth transition to a new macroeconomic environment. Separately, ABRRs offer opportunities for increased seigniorage revenue as fiscal policy capacity runs out of steam, imposing an economically efficient tax on FIs.

Finally, as the above arguments suggest, ABRRs render monetary policy relevant as a development instrument in the continuously transforming global financial economy.

A variant of ABRRs exists today in the US insurance industry, where overseeing agencies (for instance, the national Association of Insurance Commissioners' Securities Valuation Office) identify insurers' assets by risk categories. Through a series of regula- tions, insurance firms are required to hold reserves against their assets for purposes of liquidity provisions.

More recently, in compliance with the Basel III accord, the Federal Reserve Board of Governors (2013) proposed a framework for a new standardized minimum liquidity requirement for large systemic banking organizations (primarily with over 250 billion US dollars in assets) that may also have significant exposure to international markets. According to the proposed liquidity requirement ratio (LCR), FIs are required to keep a minimum amount of high-quality liquid assets (narrowed down to central bank reserves and public and private debt easily convertible into cash) measured up to 100 per cent of the FIs' net cash outflow over a 30-day period. The rules are being clarified at the time of writing (in 2014) and are expected to advance the new and stricter regulatory environ- ment ahead (by 2017) of the analogous Basel III implementation phase (scheduled for 1 January 2019).

Similar regulatory requirements are being imposed on banks in China with a 100 per cent LCR by the 2018 target in an effort to stem excessive interbank lending and sporadic cash dry-outs in the Chinese financial system. How far the new Basel III- inspired LCR rule (on top of capital adequacy rules) will go in ensuring global financial system stability is yet to be seen. For now, it appears to be consistent with the original ABRRs vision designed for a wider-scale application, as the financial system absorbs and adapts to new requirements and operational changes.

The ultimate goal behind the ABRRs proposal is greater financial stability across all FIs in the economy.

See also:

Asset price inflation; Basel Agreements; Bubble; Capital requirements; Credit bubble; Debt crisis; Financial bubble; Financial crisis; Financial instability; Housing bubble; Macro-prudential policies.