Cash Reserve Ratios and Banking Reserve Behavior.

Variations in observed values for cash reserve ratios in a banking system have traditionally been taken as reflecting changes in the preference of the banks for cash reserves. The reasoning is that banks have a preference for reserves which can be expressed as a desired ratio of reserves to deposits and that banks, in responding to this preference, make the actual value of the reserve ratio conform to the desired value. Hence, observed values of the ratio of reserves to deposits are implicitly accepted as revealing bank reserve behavior. The purpose of this paper is to point out that this implicit acceptance cannot be made when bank reserve behavior is governed by past deposits and not by current deposits. In that case, bank reserve preference must be expressed as a desired ratio of reserves in a given period to deposits of a previous period, not deposits of the same period. The possibility of banks basing reserve behavior on past deposits arises when legal reserve requirements for any given period are based on past deposits. Canadian experience supports this. In Canada, where legal reserve requirements are based on past deposits, bank reserve behavior is governed by past deposits, not by deposits of the current period. With the recent amendment in the reserve requirement rules for American banks, which provides for the calculation of required reserves on the basis of average deposits two weeks earlier,[1] a similar behavior pattern may now exist in the United States--hence, the relevance at this time of considering the significance of reserve behavior based on past deposits for the interpretation of reserve ratios. Thus, econometric studies of American banking, before using observed reserve ratio values to measure bank reserve behavior, will have to ascertain that American banks under the new reserve requirement rules still base their reserve preference on current deposits and not on the deposits of two weeks earlier. From our knowledge of Canadian bankin... [ABSTRACT FROM AUTHOR]