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Bank earning asset behavior and causality between reserves and money
Journal of Monetary Economics I2 (1983) 331-341. North-Holland
RANK EARNING ASSET REHAV R AND CAUSALITY BETWEEN RESERVES aNIB MONEY tagged versus Contemporaneous Reserve Accounting
Vefa TARWAN” LqlrgloUnilpQtsity,Chicwo,
IL 6061 I, USA
Paul A. SPIND-P
This paper empirically examines the impact of lagged reserve accounting on large individual bank behavior. Its spceifie objective is to assessthe claim that the institution of LRA has led to a decoupling of the earning asset and reserve adjustment decisions of banks. To accompli!;h this objective. a system of equations which jointly describe the reserve adjustment and earning asset decisions of banks is estimated and tested for differences in the model between the Feriods before and after 19&X It is found that bank behavior does not differ fundamentally under LRA. Evidence that ,%anka make their earning asset adjustments promptly and that expected Future interest rates are important in their decisions is also presented.
1. Introduction Lagged reserveaccounting(LRA), whereby the reserves banks are required to maintain on balance during any given week are computed based on deposit levels of two weeks previous,has come under increasing scrutiny in recent years.* The cbntroversyhas intensrfiedwith the Fed’s recent shift in operating strategy towards a policy of regulating changes in a reserve gate rather than an interest rate in its effort to manage the money A criticism of LRA which is heard in this discussion is that under LRA it is banks9and not the Fed, who control the current money supply. I’he argument runs that under LRA banks are able to select a level of loans and other earning assetsand an associatedstock of induced deposits which is ent of their current reser~ posi n. Whatever level of deposits the system thereby produces,two ks later the Federal &serve will have to ante up reserves in suffkient quantity to accomodate the predetermined level of required reserves if default is to be avoided. Thus, required reservesdo not eff’tively meter the pace of deposit expansion We have benefitted from the helpful comments of George Kaufman. Nick Lash and an anonymous referee.
0304-3923/83/$3.W
&? 1983. Elsevier Science Publishers B.V. (North-Holland)
332
V Tarhan and Y.A. Spindt, Bank earningasset behauior, resertwsand money causality
under LRA. While the extreme case of a runaway banking system is not
observed, Feige and McGee (1977) report convincing evidence to the effect that since September, 1968, when LRA was inaugurated, money has ‘Granger caused’ reserves with a two week lag. The argument outlined above hinges crucially on the independence (at least at thy: margin) of banks* earning asset decisions and their present reserve position. In this paper, we argue that these are not unconnected aspects of bank behavior but are related via a present value cost function whatever the reserve accounting regime in force. Our specific objective is to empirically assess the claim that LRA has led to a decoupling of the earning asset and reserve adjustment decisions of banks. This objective is accomplished by estimating a system of equations which jointly describe the reserve adjustment and earning asset decisions of commercial banks and testing for differences in the model between the periods before and after the institution of LRA in late 1968. The underlying model of bank behavior employed in deriving the equations to be estimated is essentially the one developed by Spindt and Tarhan (1978). Individual banks are assumed to minimize total present value costs of balance sheet adjustment given forecasts of relevant interest rates and anticipated reserve pressure over some multiperiod time horizon. The multiperiod aspect of the model is especially relevant in an LRA world, since under such a regime banks make their earning asset adjustment decisions mindful of the consequences vis a vis their reserve position two weeks hence. The remainder of the paper is organized as follows: In section 2, the impact of LRA is examined first from the point of view of the individual bank and then from the viewpoint of the banking system as a whole. The question of how the effects of LRA depend on the Fed’s operating policy is also discussed. The empirical system of equations to be estimated is proposed in section 3. The statistical results are presented in section 4. Section 5 contains our conclusions. By way of preview, our primary findings are these: first, there is no difference in bank behavior under LRA and contemporaneous reserve accounting (CRA). This implies that the institution of LRA has not led to a significant decoupling of the earning asset and reserve adjustment decisions of banks. Second, banks generally do not postpone reserve position adjustment. That is, even under LRA 8~bank’s current reserve adjustment decision is more strongly related to current deposits than to lagged deposits. Third, expected future reserve costs are an important determinant of bank behavior under either reserve accounting regime 2. LRA, bank behavior, and monetary control In response to present or anticipated disequilibrium in its reserve position,
V. Tab
and PA. Spindc. Bank earning asset behaaior. resews
and money causality
333
a bank may apply various instruments of baiance sheet adjustment. These instruments include the bank’s level of earning assets (EA), its net position in Federal funds (NFF), discount window borrowings (BFR), certificates of deposits (CD), Excel reserves (ER), reserve carryover (CO), and possibly as of adjustments (A%#)-2 As a reserve adjustment tool each of these balance sheet items operates by affecting either the bank’s current reserve balance or ii;3 required re rvcs. Changes in EA and the induced changes in deposits duct both the current reserve balance and required reserves two weeks hence under ERA and rves currently maintained and required under a contemporaneous reserve aeesunting (CRA) regime. Each of the other items, in their roles as instruments of we adjustment, affect only current reserve Balances under either recounting regime.3 For the banking system as a whole, these effects are the same as for individual banks except that net transactions in federal funds must, of course, amount to zero apart from repurchase a ments (RPs). The impact of RPs on an individual bank is to its required serves (either presently or in two weeks, depending on the reserve accounting regime) if the RP originates as a deposit in that same bank and to increase the current reserve balance if &e RP originates as a deposit of fame other bank. For the banking system, the effect of RPs is only to reduce required reserves (assuming, of course, that the public’s demand for currency is una&cted). When an individual bar& experiences a reserve inflow, the EA expansion that can be supported by this inflow depends on the reserve accounting regime in force and the bank’s (marginal) propensity to hold excess reserves. In an atomistic banking system, this earning asset expansion:exogenous reserve inflow multiplier will also depend on what proportion of the change in deposits induced by the change in earning assets is lost to other banks through the payments mechanism. The larger the proportion of induced deposits that spills over onto the balance sheets af other banks, the smaller the EA expansion can be supported by a given inflow of reserves. In the extreme case, when the redeposition rate is zero, the multiplier will be at most one under LRA and at most one minus the marginal reserve requirement ratio under CRA, At the other extreme when, as for a monopoly bank or the banking system as a whale, the redeposition rate is one.’ the
334
K Tarhan and P.A. Spindt, Bank earning asset bekauior, reserves und money causality
multiplier can be at most one over the marginal reserve requirement ratio under CRA but has no upper limit under LRA. Thus under LRA both for the individual bank in an atomistic community of banks and for the banking system as a whole, the theoretical ceiling on EA expansion that can be supported by a reserve inflow is always higher than under CRA, and the differenceis greater the greater the average redeposition rate. These facts underlie the concern stated in the introduction above, that under LRA the Fed loses control over the current level of deposits. To see how this might happen, consider the following situation: Suppose money growth is running above ‘path’ and the Fed wishes to slow it down. Toward this end it engages in an open market sale of securities, thereby reducing non-borrowed reserves. This action generates reserve pressure for the banking system as a whole and for at least one individual bank (i.e., the one which bought the securities the Fed sold) which can only be alleviated in the end by an adjustment of EA. For the moment, however, any individual bank can postpone adjusting its EA and the associated deposits by utilizing the balance sheet instruments listed above. The adjustment of the system as a whole can only be postponed to the extent that banks take turns borrowing at the discount window. Under CRA required reserves fall simultaneously with deposits, so if banks make their EA adjustments promptly, the reserve pressure can be eliminated in the same week as the open market action by the Fed which generated it. Under LRA, however, even if banks adjust their EA without delay, the reserve pressure cannot be alleviated in the same week. This is the basis on which LRA is criticized: Since there is no accounting link between current required reserves and current deposits, the Fed will have to supply any deficiency of actual reserves over required reserves either through an open discount window, defensive securities purchases or defacto by forgiving those banks who default on their requirements. Thus, under LRA reserves are effectively endogenous, being substantiahy determined by deposit levels of two weeks ago. Fei and McGee (1977) report empirical evidence to this effect: After 1968 money has ‘Granger caused’ reserves with a two week lag, The observed exogeneity of money with respect to reserves cannot, however, be unambiguously ascribed to the reserve accounting regime, (although this, presumably, is the source of the two week lag), because throughout this period, the Fed was following an interest rate operating rule? Clearly, no matter what the reserve accounting regime, money will ‘Granger cause’ reserves under an i‘tterest rate operating strategy. Suppose, for instance, that banks experience an increase in the demand for credit. As banks react to the profitable opportunities presented them, bank earning assets will expand inducing an increase in deposits and the Fed funds rate ‘Apart from a brief episode in 1972 during which RPD’s (reserves against private deposits) were targetted. See Wallich and Keir (1978).
K Twhan
and
P.A.
Spindt. Bank earning asset bdtatkr.
wwwes
and money causalit!
335
will be bid up above its targetted level. Required reserves will also increase either in the current period or two weeks later depending on the reserve accounting regime, and this puts additional upward pressure on the funds rate. In order to restore the funds rate to its target path, the Fed must end up supplying rt~tves. Data generated under such an operating policy will show money exe cws with respect to reserves whatever the reserve accounting regime. In the literature criticizing LRA, an obvious aspect of bank decision making is uniformly overlooked: Faced with a current reserve disequilibrium, a profit maximizing bank makes its decision about how much to adjust its BA now and how much to postpone until later based on its assessment of expected costs rve pressure over some multiperiod time horizon. This is true under a rve accounting regime. The intertemporal connection is explicit under inQe current EA decisions feed forward and affect required reserves two weeks in the future. But the multiperiod horizon will be equally characteristic of behavior under CRA in a world of non-trivial adjustment costs. It is possible, therefore, that bank EA adjustment behavior under the two regimes will be quite similar. To see this, consider again the situation in which the Fed conducts open- market sales of securities in an effort to bring the growth of mo&y back down to path. It is true under LRA that if non-borrowed reserves are reduced below the level of required reserves, the Fed will have to supply reserves at the discount window. But if banks expect their costs elf adjustment to be substantially higher two weeks hence, they may adjust their current level of EA (with the implied adjustment in induced deposits following), in addition to borrowing reserves to cover their current reserve requiremeri;. This mix of current and postponed adjustment would likely be very sim’lar under CRA. In particular, if banks behave in this manner, the Fed’s effort to contract deposits by lowering non-borrowed reserves will be about as s- 2essful under LRA as under CRA. From the analysis of th,:, section it can be seen that the Fed’s control over current deposit levels dcwnds not so much on the particular reserve accounting rule as on the eletcnt tu wir;& the Fed is able to induce banks to adjust their EA promptly and not postpone adjustment until some later period. The reserve accountin regime affects this inducement in the sense that seteris pnriihus the cost of current adjustment relative to delayed adjustment is lower under CRA than under LRA. Rut at worst. this built in advantage to prompt EA adjustment under CRA simply means that monetary control using a non-borrowed reserves operating target is less efficient under LRA It does not mean that monetary control is infeasible, (or ntroi ercusabic). Kaufman (1981) has proposed a means of the pos,sibie inefYiciencyof LRA: He suggests the Fed accompany its open market operations in the current week with an announcement as to what the discount r Ite will be in two weeks.
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K Twhun and P.A. Spindt,Bank earning usset behavior, resews and money causality
3. The empirical model The environment in which a bank makes its reserve position adjustment decision under LRA and CRA has been described above. Under either system the objective of the bank is to choose its adjustments such that the total cost of adjustment is minimized. To achieve this goal, it is assumed that the individual bank forecasts the reserve pressure it will experience,and the costs it will face, during the present period and at least over the next two periods. Thus in this model, a bank is interested in the scale and cost of both current and future periods reserve adjustments. In addition to exogenous changes in the bank’s deposit stock and variation in local loan demand, macro forces, including changes in the outstanding volume or distribution of bank reserves and shifts in money market demands and supplies, also impinge on the bank’s adjustment plans. By combining its expectations about these exogenous conditions with some prediction about the intent of Federal Reserve policy, the bank is able to arrive at a reserve adjustment plan which minimizes its expected present value cost of adjustment. The empirical question is whether or not this behavior has been fundamentally altered by the September 1968 changes in Regulation II. For purposes of this paper, we distinguish the balance sheet categories itemized in table 1. The bank is viewed as being a price taker in all markets. To describe bank behavior empirically we estimate a specific form of the general Fdgeworth stock-out model in which the forecast horizon has been limited to two periods. The general model is derived by solving a multiperiod optimization problem in which the bank incurs costs of adjustment and disequilibrium.6 In particular, the estimated form of the model is given by
where LIis the first difference operator, R, is a vector of the five cndogenous portfolio items listed in table 1, X, is a vector consisting of the exogenous variables listed in table 1, e, is a vector of stochastic disturbances, the r’s are matrices of coeficients, and the carat above a vector indicates that it is a forecasted value.’ 6The generalmodel is derivedrigorouslyby Spindt and Tarhan (1978). ‘The di.lIerencedform of the model is estimated in view of the strong likelihood that the disturbancesin the level form are severely autocorrelated.The forecasts used were devolo from univariateARIMA models fit to each time series.Details of khe available from the authors on request. In view of the balance sheet column sums of the f3 in (1) are restrictedand the covariance matri singular. Spindt (1981) has shown that for models such as (1) equation by equation C&S will generateestimateswhich satisfy this cross equation restrictionif and only if the data satisfy tue balance sheet identity.
b! ‘lhrhan
and
P.A.
Spindt, Bank awning
asset beh*ior.
reserves and money causality
337
Table 1 List of variables.’ Mnemonic
ption
Status Endogenous
ts (loans and investments) Federal funds including repurchase agreement transactions
Endogmous
negotiable certificates of deposits
Endogmous
Borrowinp from Federal Reserve banks
Endogenous
Excess rez%crves Deposits exclusive of CD3
Total loans of large banks excluding NCV York Cit! hanks (loan demand proxy) MBR
fxogenous
Member bank reserves
PFF
Exogenous
Commercial paper rate (4-6 months) minus the Federal funds rate
DISC
Exogenous
Dbcount rate
Vutu wurce: kderal
Reserve Bu/Ierin, various issues.
The five equation system (1) was estimated for the combined balance sheet of eight large New York City Banks by least squares over two disjoint sample periods. During the first, from July 7, 1965 through June 25, 1968. CRA was in eff’eetand during the later period, May 5, 1971 through April 28, 1976, LRA was the reserve accounting regime. Estimates of selected mode4 coefficients are tabulated in table 3. Complete results are available from the authen on requat. Table 2 reports the results of Chow testsof the hypothesis that the model eaeficient~ are the same for both periods. In no case can we reject the hypothesisof no differenceat the 5 percent level of confidence. These are z;ults;.They indicate that the institution of LRA has not led to any significant changesin bank earnin asset.reserve adjustment behavior.8 ~on~lu~~~n is reinforced by the visual comparison of the cients ~r~~~nted in table 3. Note particularly how similar the estimatec! ~~~~~~~nts on current and expected future deposits and lagged deposits Are between the two periods. “When the coefficient on the owqwiwi ahead forecast of the interest rate spread is deleted from thr Chow test, the tdl arw of the d&A test becomes 0.131 and the tail area of the JER test becomes 0 I18. Since the coeficients on this variable are insignificant in the CR.4 period, this suggests that expected rates may have become a more important determinant of bank behavior during the LRA period
33,B
V: Tarhan and P.A. Spin& Bunk earning asset behavior, rewrves and money ruusulitg
Table 2 Tests of the hypothesis of no difference in the model coefficients due to reserve accounting regime. Equation
F-statistic’
Tail area of test
AEA AER ANFF ABFR ACD
1.5271 1.5164 0.8900 0.6636
0.0817 0.0852 0.5868 0.8391 0.3810
1.0704
‘17 and 384 df,
Table 3 Selected coefficient estimates’ and summary statistics. Summary statistics
Exogenous variable Accounting Equation regime AEA
CRA LRA
AER
CRA LRA
ABFF
CRA LRA
ABFR
ADEP,_ I
(-0.21)
0.388 (7.98)
-0.033 (- 1.71)
0.22 1 (4.52)
-0.002
0.016 (2.59)
-0.004
(-1.10) 0.002 (0.66) -0.015 ( - 0.87) -0.14 ( - 0.62)
CRA (8:; LRA
ACD
CRA LRA
ADEP,
-0.011 (- 1.03) 0.002 (0.24) -0.005 ( -0.68)
ADEP,,,
ADEP, e 2
Rz
D.W
0.103 (1.64) -0.140 (-1.82) -0.016 (-1.99)
0.788
2.08
0.512
2.15
0.378
2.13
0.214
2.37
0.699
2.05
0,646
2.09
0.247
2.23
0.313
2.19
( - 0.0~)
0.117 (2.17) -0.141 ( - 2.07) -0.009 ( - 1.JO) 0.016 (1.37) 0.088 (1.75) -0.106 ( - 1.34) 0.010 (0.36) 0.023 (0.59)
0.023 (0.87) - 0.044 (- 1.41)
0.010 (0.44) -0.041 (-1.49)
0.302
1.86
0.559
2.4.;
0.024 (2.91)
(X:g 0.030 (0.50)
- 0.472 (-10.41) -0,579 (-10.14) -0,060 ( - 2.42) -0.093 ( - 3.33) - 0.063 ( - 3.08)
-0.081 ( - 4.06)
-0,085 0.95) 0.034 ( I .07) -0.002
(-
‘t-statistics are reported in parentheses below the coellicient estimates.
K Tarhan and PA. Spindt, Bank earning asset hehaaior, reserves und money causalit?
339
As expected, when deposits in the current period increase, banks increase their earning assets and excess reserves, and decrease their net purchased position in F’ed funds, their discount window borrowings and total outW#nding CD issue. This response is observed for both sample periods and the re sion coefficients are’ very highly significant. But, what is more remarkable is the fact that the coefficients for the LRA period are very similar to their counterparts from the CRA period. In response to a one dollar de it inflow, earning assets increased by 39 cents for the CRA geriad and 22 cents for the LRA period, net Fed funds purchased declines by 47 cents and 58 cents for the CRA and LRA period respectively, discount window borro are reduced by 6 cents, CDs by 6 cents and excess reserves increa y about 2 cents during the CRA period, while during LRA, discount window borrowings are reduced by 9 cents, CDs by 8 cents, and EB are again increased by about 2 cents. This similarity is particularly remarkable in view of the fact that the environment in which banks operated changed substantially over the entire period. In the post 1968 period, for example, there have been dramatic innovations in the use of financial markets by banks in the form of heavy reliance on CDs in financing loans, changes in the nature and scale of the markets for Federal funds and commercial paper, and development of liability management strategies, etc. In spite of all these changes, individual bank behavior under LRA exhibits a strong similarity to bank behavior during the period when CRA was in effect. Significantly, despite the fact observed in section 2 above that the theoretical limit to bank earning asset expansion is higher under LRA than under CRA, bank EA expansion in response to a deposit increase for the LRA period is actually less than for the CRA period, This result indicates that the decoupling of bank earning asset expansion from reserve constraints which is possible under LRA has not taken place. Based on this evidence, the observation that money cause&s reserves cannot be accounted for by the claim of an unconstrained banking system. Additional evidence that the switch to LRA has not fundamentally altered bank behavior can be found by examining the response to changes in the level sf bank deposits o periods ago. As expected, the endogenous riod are not significantly affected by changes in variables in the current deposits that take place two weeks ago under CBA. But for LRA it is argued that in week I, banks would borrow in the money markets and liquidate their assets in response to an increase in deposits in week r -2. This is possible only if banks regularly postpone their balance sheet adjustment as long as possible, If the tirling of their adjustment depends on the comparison of expected future tith current costs, then the relationship between current endogenous variables and past changes in deposits will likely not be strong. The results reported in table 3 support this view. Evidently. there is no significant impact of t hanges in deposits in period r - 2 on the balance sheet
340
K Tarhan and P.A. Spilt, Bank earning asset behavior, te.wrvesand monq causality
adjustment variables in period t, Banks appear to be quite prompt in their adjustment behavior and this fact is not affected by choice of re accounting regimes. Unreported estimates describing bank response to changes in interest rates are broadly insignificant. Interestingly, however, bank r-ponse to expected future rates appears to be stronger than to current rates. Under LRA, for example, both earning assets and federal funds purchases increase in response to an expected increase in the spread between the commercial paper rate and Fed funds rate in period t + 1. An expected increase in this spread in period t + 2 generates a CD response in period t. These results suggest that the expected Pature costs of reserve position adjustment are a significant determinant of current adjustment behavior. in light of these results, we suggest that the reported unidirectional causation running from money to reserves is more a consequence of the Federal Reserve’s choice of operating strategy than of the reserve accounting regime. Unfortunately, since the Fed only recently shifted over to a reserve aggregate from an interest rate operating strategy, the data record is simply too short to assess the correctness of this explanation. But given a sufficiently sustained commitment by the Fed to its current non-borrowed reserves operating strategy, this suggestion will one day be empirically testable. We conjecture that reserves will be found to be exogenous with respect to money eten under LRA. 5. ConeludIng remarks
This paper has attempted to empirically assess the impact of the institution of LRA on individual bank behavior as part of the larger question of how LRA affects monetary control, The estimated equations for the period before and after the introduction to LRA indicate bank behavior was little changed, Mween the two periods. We find no empirical merit in the argument that LRA has resulted in a decoupling of the earni asset and reserve adjustment decisions of ban,ks even though current reserves and current earning asset adjustment has been severed, We find that banks adjust their balance sheets promptly under either accounting regime and that. expected future costs are important in the bank’s current decision making,
k, D.C., 1981, Excess reservesand reserve targeting,Federal Reserve Bank ef NW Ywk QuarterlyReview 6, U-22. Coats, W.L., 1976, Lagged reserve accounting and the money supply mechanism, Journn! of Money,Credit,and Ranking8,167~180.
K 7imhtu &
P.A. Spindt. Bank ewning asset behaoior. reserws and money causality
341
reserve accounting, Journal the reserve adjustment pressure and the economy 3rd ed (Houghton
Mifllin,
in the wrong direction? Journal of reserve accounting, Journal of Money, targeting and monetary control, Paper presented at ving Money Stock Control: Problems, solutions. and eml Reserve Rank of St. Louis and the Center of the
struments under lagged reserve rtments in the United States, Spit&, PA., 1981, A note on the estimation of financial models, Mimeo. Spindt, P.A. and V. Tarhan, 1978, A model of large bank liquidity adjustment, Special Studies paper no. 121, Boatd of Govemon of the Federal Reserve System, Washin on? DC. Spindt, P.A. and V. Tarhan, 19g0, Liquidity structure adjustment behavior of Parge money center buka Journal of Money, Credit, and Ranking 12,19&208. Wallicb, H. and P. Keir, 197% Tba rok of operating guides in U.S. monetary policy: A historical review, Krcdit and Kapitrl, forthcoming.
RANK EARNING ASSET REHAV R AND CAUSALITY BETWEEN RESERVES aNIB MONEY tagged versus Contemporaneous Reserve Accounting
Vefa TARWAN” LqlrgloUnilpQtsity,Chicwo,
IL 6061 I, USA
Paul A. SPIND-P
This paper empirically examines the impact of lagged reserve accounting on large individual bank behavior. Its spceifie objective is to assessthe claim that the institution of LRA has led to a decoupling of the earning asset and reserve adjustment decisions of banks. To accompli!;h this objective. a system of equations which jointly describe the reserve adjustment and earning asset decisions of banks is estimated and tested for differences in the model between the Feriods before and after 19&X It is found that bank behavior does not differ fundamentally under LRA. Evidence that ,%anka make their earning asset adjustments promptly and that expected Future interest rates are important in their decisions is also presented.
1. Introduction Lagged reserveaccounting(LRA), whereby the reserves banks are required to maintain on balance during any given week are computed based on deposit levels of two weeks previous,has come under increasing scrutiny in recent years.* The cbntroversyhas intensrfiedwith the Fed’s recent shift in operating strategy towards a policy of regulating changes in a reserve gate rather than an interest rate in its effort to manage the money A criticism of LRA which is heard in this discussion is that under LRA it is banks9and not the Fed, who control the current money supply. I’he argument runs that under LRA banks are able to select a level of loans and other earning assetsand an associatedstock of induced deposits which is ent of their current reser~ posi n. Whatever level of deposits the system thereby produces,two ks later the Federal &serve will have to ante up reserves in suffkient quantity to accomodate the predetermined level of required reserves if default is to be avoided. Thus, required reservesdo not eff’tively meter the pace of deposit expansion We have benefitted from the helpful comments of George Kaufman. Nick Lash and an anonymous referee.
0304-3923/83/$3.W
&? 1983. Elsevier Science Publishers B.V. (North-Holland)
332
V Tarhan and Y.A. Spindt, Bank earningasset behauior, resertwsand money causality
under LRA. While the extreme case of a runaway banking system is not
observed, Feige and McGee (1977) report convincing evidence to the effect that since September, 1968, when LRA was inaugurated, money has ‘Granger caused’ reserves with a two week lag. The argument outlined above hinges crucially on the independence (at least at thy: margin) of banks* earning asset decisions and their present reserve position. In this paper, we argue that these are not unconnected aspects of bank behavior but are related via a present value cost function whatever the reserve accounting regime in force. Our specific objective is to empirically assess the claim that LRA has led to a decoupling of the earning asset and reserve adjustment decisions of banks. This objective is accomplished by estimating a system of equations which jointly describe the reserve adjustment and earning asset decisions of commercial banks and testing for differences in the model between the periods before and after the institution of LRA in late 1968. The underlying model of bank behavior employed in deriving the equations to be estimated is essentially the one developed by Spindt and Tarhan (1978). Individual banks are assumed to minimize total present value costs of balance sheet adjustment given forecasts of relevant interest rates and anticipated reserve pressure over some multiperiod time horizon. The multiperiod aspect of the model is especially relevant in an LRA world, since under such a regime banks make their earning asset adjustment decisions mindful of the consequences vis a vis their reserve position two weeks hence. The remainder of the paper is organized as follows: In section 2, the impact of LRA is examined first from the point of view of the individual bank and then from the viewpoint of the banking system as a whole. The question of how the effects of LRA depend on the Fed’s operating policy is also discussed. The empirical system of equations to be estimated is proposed in section 3. The statistical results are presented in section 4. Section 5 contains our conclusions. By way of preview, our primary findings are these: first, there is no difference in bank behavior under LRA and contemporaneous reserve accounting (CRA). This implies that the institution of LRA has not led to a significant decoupling of the earning asset and reserve adjustment decisions of banks. Second, banks generally do not postpone reserve position adjustment. That is, even under LRA 8~bank’s current reserve adjustment decision is more strongly related to current deposits than to lagged deposits. Third, expected future reserve costs are an important determinant of bank behavior under either reserve accounting regime 2. LRA, bank behavior, and monetary control In response to present or anticipated disequilibrium in its reserve position,
V. Tab
and PA. Spindc. Bank earning asset behaaior. resews
and money causality
333
a bank may apply various instruments of baiance sheet adjustment. These instruments include the bank’s level of earning assets (EA), its net position in Federal funds (NFF), discount window borrowings (BFR), certificates of deposits (CD), Excel reserves (ER), reserve carryover (CO), and possibly as of adjustments (A%#)-2 As a reserve adjustment tool each of these balance sheet items operates by affecting either the bank’s current reserve balance or ii;3 required re rvcs. Changes in EA and the induced changes in deposits duct both the current reserve balance and required reserves two weeks hence under ERA and rves currently maintained and required under a contemporaneous reserve aeesunting (CRA) regime. Each of the other items, in their roles as instruments of we adjustment, affect only current reserve Balances under either recounting regime.3 For the banking system as a whole, these effects are the same as for individual banks except that net transactions in federal funds must, of course, amount to zero apart from repurchase a ments (RPs). The impact of RPs on an individual bank is to its required serves (either presently or in two weeks, depending on the reserve accounting regime) if the RP originates as a deposit in that same bank and to increase the current reserve balance if &e RP originates as a deposit of fame other bank. For the banking system, the effect of RPs is only to reduce required reserves (assuming, of course, that the public’s demand for currency is una&cted). When an individual bar& experiences a reserve inflow, the EA expansion that can be supported by this inflow depends on the reserve accounting regime in force and the bank’s (marginal) propensity to hold excess reserves. In an atomistic banking system, this earning asset expansion:exogenous reserve inflow multiplier will also depend on what proportion of the change in deposits induced by the change in earning assets is lost to other banks through the payments mechanism. The larger the proportion of induced deposits that spills over onto the balance sheets af other banks, the smaller the EA expansion can be supported by a given inflow of reserves. In the extreme case, when the redeposition rate is zero, the multiplier will be at most one under LRA and at most one minus the marginal reserve requirement ratio under CRA, At the other extreme when, as for a monopoly bank or the banking system as a whale, the redeposition rate is one.’ the
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K Tarhan and P.A. Spindt, Bank earning asset bekauior, reserves und money causality
multiplier can be at most one over the marginal reserve requirement ratio under CRA but has no upper limit under LRA. Thus under LRA both for the individual bank in an atomistic community of banks and for the banking system as a whole, the theoretical ceiling on EA expansion that can be supported by a reserve inflow is always higher than under CRA, and the differenceis greater the greater the average redeposition rate. These facts underlie the concern stated in the introduction above, that under LRA the Fed loses control over the current level of deposits. To see how this might happen, consider the following situation: Suppose money growth is running above ‘path’ and the Fed wishes to slow it down. Toward this end it engages in an open market sale of securities, thereby reducing non-borrowed reserves. This action generates reserve pressure for the banking system as a whole and for at least one individual bank (i.e., the one which bought the securities the Fed sold) which can only be alleviated in the end by an adjustment of EA. For the moment, however, any individual bank can postpone adjusting its EA and the associated deposits by utilizing the balance sheet instruments listed above. The adjustment of the system as a whole can only be postponed to the extent that banks take turns borrowing at the discount window. Under CRA required reserves fall simultaneously with deposits, so if banks make their EA adjustments promptly, the reserve pressure can be eliminated in the same week as the open market action by the Fed which generated it. Under LRA, however, even if banks adjust their EA without delay, the reserve pressure cannot be alleviated in the same week. This is the basis on which LRA is criticized: Since there is no accounting link between current required reserves and current deposits, the Fed will have to supply any deficiency of actual reserves over required reserves either through an open discount window, defensive securities purchases or defacto by forgiving those banks who default on their requirements. Thus, under LRA reserves are effectively endogenous, being substantiahy determined by deposit levels of two weeks ago. Fei and McGee (1977) report empirical evidence to this effect: After 1968 money has ‘Granger caused’ reserves with a two week lag, The observed exogeneity of money with respect to reserves cannot, however, be unambiguously ascribed to the reserve accounting regime, (although this, presumably, is the source of the two week lag), because throughout this period, the Fed was following an interest rate operating rule? Clearly, no matter what the reserve accounting regime, money will ‘Granger cause’ reserves under an i‘tterest rate operating strategy. Suppose, for instance, that banks experience an increase in the demand for credit. As banks react to the profitable opportunities presented them, bank earning assets will expand inducing an increase in deposits and the Fed funds rate ‘Apart from a brief episode in 1972 during which RPD’s (reserves against private deposits) were targetted. See Wallich and Keir (1978).
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and money causalit!
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will be bid up above its targetted level. Required reserves will also increase either in the current period or two weeks later depending on the reserve accounting regime, and this puts additional upward pressure on the funds rate. In order to restore the funds rate to its target path, the Fed must end up supplying rt~tves. Data generated under such an operating policy will show money exe cws with respect to reserves whatever the reserve accounting regime. In the literature criticizing LRA, an obvious aspect of bank decision making is uniformly overlooked: Faced with a current reserve disequilibrium, a profit maximizing bank makes its decision about how much to adjust its BA now and how much to postpone until later based on its assessment of expected costs rve pressure over some multiperiod time horizon. This is true under a rve accounting regime. The intertemporal connection is explicit under inQe current EA decisions feed forward and affect required reserves two weeks in the future. But the multiperiod horizon will be equally characteristic of behavior under CRA in a world of non-trivial adjustment costs. It is possible, therefore, that bank EA adjustment behavior under the two regimes will be quite similar. To see this, consider again the situation in which the Fed conducts open- market sales of securities in an effort to bring the growth of mo&y back down to path. It is true under LRA that if non-borrowed reserves are reduced below the level of required reserves, the Fed will have to supply reserves at the discount window. But if banks expect their costs elf adjustment to be substantially higher two weeks hence, they may adjust their current level of EA (with the implied adjustment in induced deposits following), in addition to borrowing reserves to cover their current reserve requiremeri;. This mix of current and postponed adjustment would likely be very sim’lar under CRA. In particular, if banks behave in this manner, the Fed’s effort to contract deposits by lowering non-borrowed reserves will be about as s- 2essful under LRA as under CRA. From the analysis of th,:, section it can be seen that the Fed’s control over current deposit levels dcwnds not so much on the particular reserve accounting rule as on the eletcnt tu wir;& the Fed is able to induce banks to adjust their EA promptly and not postpone adjustment until some later period. The reserve accountin regime affects this inducement in the sense that seteris pnriihus the cost of current adjustment relative to delayed adjustment is lower under CRA than under LRA. Rut at worst. this built in advantage to prompt EA adjustment under CRA simply means that monetary control using a non-borrowed reserves operating target is less efficient under LRA It does not mean that monetary control is infeasible, (or ntroi ercusabic). Kaufman (1981) has proposed a means of the pos,sibie inefYiciencyof LRA: He suggests the Fed accompany its open market operations in the current week with an announcement as to what the discount r Ite will be in two weeks.
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K Twhun and P.A. Spindt,Bank earning usset behavior, resews and money causality
3. The empirical model The environment in which a bank makes its reserve position adjustment decision under LRA and CRA has been described above. Under either system the objective of the bank is to choose its adjustments such that the total cost of adjustment is minimized. To achieve this goal, it is assumed that the individual bank forecasts the reserve pressure it will experience,and the costs it will face, during the present period and at least over the next two periods. Thus in this model, a bank is interested in the scale and cost of both current and future periods reserve adjustments. In addition to exogenous changes in the bank’s deposit stock and variation in local loan demand, macro forces, including changes in the outstanding volume or distribution of bank reserves and shifts in money market demands and supplies, also impinge on the bank’s adjustment plans. By combining its expectations about these exogenous conditions with some prediction about the intent of Federal Reserve policy, the bank is able to arrive at a reserve adjustment plan which minimizes its expected present value cost of adjustment. The empirical question is whether or not this behavior has been fundamentally altered by the September 1968 changes in Regulation II. For purposes of this paper, we distinguish the balance sheet categories itemized in table 1. The bank is viewed as being a price taker in all markets. To describe bank behavior empirically we estimate a specific form of the general Fdgeworth stock-out model in which the forecast horizon has been limited to two periods. The general model is derived by solving a multiperiod optimization problem in which the bank incurs costs of adjustment and disequilibrium.6 In particular, the estimated form of the model is given by
where LIis the first difference operator, R, is a vector of the five cndogenous portfolio items listed in table 1, X, is a vector consisting of the exogenous variables listed in table 1, e, is a vector of stochastic disturbances, the r’s are matrices of coeficients, and the carat above a vector indicates that it is a forecasted value.’ 6The generalmodel is derivedrigorouslyby Spindt and Tarhan (1978). ‘The di.lIerencedform of the model is estimated in view of the strong likelihood that the disturbancesin the level form are severely autocorrelated.The forecasts used were devolo from univariateARIMA models fit to each time series.Details of khe available from the authors on request. In view of the balance sheet column sums of the f3 in (1) are restrictedand the covariance matri singular. Spindt (1981) has shown that for models such as (1) equation by equation C&S will generateestimateswhich satisfy this cross equation restrictionif and only if the data satisfy tue balance sheet identity.
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Table 1 List of variables.’ Mnemonic
ption
Status Endogenous
ts (loans and investments) Federal funds including repurchase agreement transactions
Endogmous
negotiable certificates of deposits
Endogmous
Borrowinp from Federal Reserve banks
Endogenous
Excess rez%crves Deposits exclusive of CD3
Total loans of large banks excluding NCV York Cit! hanks (loan demand proxy) MBR
fxogenous
Member bank reserves
PFF
Exogenous
Commercial paper rate (4-6 months) minus the Federal funds rate
DISC
Exogenous
Dbcount rate
Vutu wurce: kderal
Reserve Bu/Ierin, various issues.
The five equation system (1) was estimated for the combined balance sheet of eight large New York City Banks by least squares over two disjoint sample periods. During the first, from July 7, 1965 through June 25, 1968. CRA was in eff’eetand during the later period, May 5, 1971 through April 28, 1976, LRA was the reserve accounting regime. Estimates of selected mode4 coefficients are tabulated in table 3. Complete results are available from the authen on requat. Table 2 reports the results of Chow testsof the hypothesis that the model eaeficient~ are the same for both periods. In no case can we reject the hypothesisof no differenceat the 5 percent level of confidence. These are z;ults;.They indicate that the institution of LRA has not led to any significant changesin bank earnin asset.reserve adjustment behavior.8 ~on~lu~~~n is reinforced by the visual comparison of the cients ~r~~~nted in table 3. Note particularly how similar the estimatec! ~~~~~~~nts on current and expected future deposits and lagged deposits Are between the two periods. “When the coefficient on the owqwiwi ahead forecast of the interest rate spread is deleted from thr Chow test, the tdl arw of the d&A test becomes 0.131 and the tail area of the JER test becomes 0 I18. Since the coeficients on this variable are insignificant in the CR.4 period, this suggests that expected rates may have become a more important determinant of bank behavior during the LRA period
33,B
V: Tarhan and P.A. Spin& Bunk earning asset behavior, rewrves and money ruusulitg
Table 2 Tests of the hypothesis of no difference in the model coefficients due to reserve accounting regime. Equation
F-statistic’
Tail area of test
AEA AER ANFF ABFR ACD
1.5271 1.5164 0.8900 0.6636
0.0817 0.0852 0.5868 0.8391 0.3810
1.0704
‘17 and 384 df,
Table 3 Selected coefficient estimates’ and summary statistics. Summary statistics
Exogenous variable Accounting Equation regime AEA
CRA LRA
AER
CRA LRA
ABFF
CRA LRA
ABFR
ADEP,_ I
(-0.21)
0.388 (7.98)
-0.033 (- 1.71)
0.22 1 (4.52)
-0.002
0.016 (2.59)
-0.004
(-1.10) 0.002 (0.66) -0.015 ( - 0.87) -0.14 ( - 0.62)
CRA (8:; LRA
ACD
CRA LRA
ADEP,
-0.011 (- 1.03) 0.002 (0.24) -0.005 ( -0.68)
ADEP,,,
ADEP, e 2
Rz
D.W
0.103 (1.64) -0.140 (-1.82) -0.016 (-1.99)
0.788
2.08
0.512
2.15
0.378
2.13
0.214
2.37
0.699
2.05
0,646
2.09
0.247
2.23
0.313
2.19
( - 0.0~)
0.117 (2.17) -0.141 ( - 2.07) -0.009 ( - 1.JO) 0.016 (1.37) 0.088 (1.75) -0.106 ( - 1.34) 0.010 (0.36) 0.023 (0.59)
0.023 (0.87) - 0.044 (- 1.41)
0.010 (0.44) -0.041 (-1.49)
0.302
1.86
0.559
2.4.;
0.024 (2.91)
(X:g 0.030 (0.50)
- 0.472 (-10.41) -0,579 (-10.14) -0,060 ( - 2.42) -0.093 ( - 3.33) - 0.063 ( - 3.08)
-0.081 ( - 4.06)
-0,085 0.95) 0.034 ( I .07) -0.002
(-
‘t-statistics are reported in parentheses below the coellicient estimates.
K Tarhan and PA. Spindt, Bank earning asset hehaaior, reserves und money causalit?
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As expected, when deposits in the current period increase, banks increase their earning assets and excess reserves, and decrease their net purchased position in F’ed funds, their discount window borrowings and total outW#nding CD issue. This response is observed for both sample periods and the re sion coefficients are’ very highly significant. But, what is more remarkable is the fact that the coefficients for the LRA period are very similar to their counterparts from the CRA period. In response to a one dollar de it inflow, earning assets increased by 39 cents for the CRA geriad and 22 cents for the LRA period, net Fed funds purchased declines by 47 cents and 58 cents for the CRA and LRA period respectively, discount window borro are reduced by 6 cents, CDs by 6 cents and excess reserves increa y about 2 cents during the CRA period, while during LRA, discount window borrowings are reduced by 9 cents, CDs by 8 cents, and EB are again increased by about 2 cents. This similarity is particularly remarkable in view of the fact that the environment in which banks operated changed substantially over the entire period. In the post 1968 period, for example, there have been dramatic innovations in the use of financial markets by banks in the form of heavy reliance on CDs in financing loans, changes in the nature and scale of the markets for Federal funds and commercial paper, and development of liability management strategies, etc. In spite of all these changes, individual bank behavior under LRA exhibits a strong similarity to bank behavior during the period when CRA was in effect. Significantly, despite the fact observed in section 2 above that the theoretical limit to bank earning asset expansion is higher under LRA than under CRA, bank EA expansion in response to a deposit increase for the LRA period is actually less than for the CRA period, This result indicates that the decoupling of bank earning asset expansion from reserve constraints which is possible under LRA has not taken place. Based on this evidence, the observation that money cause&s reserves cannot be accounted for by the claim of an unconstrained banking system. Additional evidence that the switch to LRA has not fundamentally altered bank behavior can be found by examining the response to changes in the level sf bank deposits o periods ago. As expected, the endogenous riod are not significantly affected by changes in variables in the current deposits that take place two weeks ago under CBA. But for LRA it is argued that in week I, banks would borrow in the money markets and liquidate their assets in response to an increase in deposits in week r -2. This is possible only if banks regularly postpone their balance sheet adjustment as long as possible, If the tirling of their adjustment depends on the comparison of expected future tith current costs, then the relationship between current endogenous variables and past changes in deposits will likely not be strong. The results reported in table 3 support this view. Evidently. there is no significant impact of t hanges in deposits in period r - 2 on the balance sheet
340
K Tarhan and P.A. Spilt, Bank earning asset behavior, te.wrvesand monq causality
adjustment variables in period t, Banks appear to be quite prompt in their adjustment behavior and this fact is not affected by choice of re accounting regimes. Unreported estimates describing bank response to changes in interest rates are broadly insignificant. Interestingly, however, bank r-ponse to expected future rates appears to be stronger than to current rates. Under LRA, for example, both earning assets and federal funds purchases increase in response to an expected increase in the spread between the commercial paper rate and Fed funds rate in period t + 1. An expected increase in this spread in period t + 2 generates a CD response in period t. These results suggest that the expected Pature costs of reserve position adjustment are a significant determinant of current adjustment behavior. in light of these results, we suggest that the reported unidirectional causation running from money to reserves is more a consequence of the Federal Reserve’s choice of operating strategy than of the reserve accounting regime. Unfortunately, since the Fed only recently shifted over to a reserve aggregate from an interest rate operating strategy, the data record is simply too short to assess the correctness of this explanation. But given a sufficiently sustained commitment by the Fed to its current non-borrowed reserves operating strategy, this suggestion will one day be empirically testable. We conjecture that reserves will be found to be exogenous with respect to money eten under LRA. 5. ConeludIng remarks
This paper has attempted to empirically assess the impact of the institution of LRA on individual bank behavior as part of the larger question of how LRA affects monetary control, The estimated equations for the period before and after the introduction to LRA indicate bank behavior was little changed, Mween the two periods. We find no empirical merit in the argument that LRA has resulted in a decoupling of the earni asset and reserve adjustment decisions of ban,ks even though current reserves and current earning asset adjustment has been severed, We find that banks adjust their balance sheets promptly under either accounting regime and that. expected future costs are important in the bank’s current decision making,
k, D.C., 1981, Excess reservesand reserve targeting,Federal Reserve Bank ef NW Ywk QuarterlyReview 6, U-22. Coats, W.L., 1976, Lagged reserve accounting and the money supply mechanism, Journn! of Money,Credit,and Ranking8,167~180.
K 7imhtu &
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341
reserve accounting, Journal the reserve adjustment pressure and the economy 3rd ed (Houghton
Mifllin,
in the wrong direction? Journal of reserve accounting, Journal of Money, targeting and monetary control, Paper presented at ving Money Stock Control: Problems, solutions. and eml Reserve Rank of St. Louis and the Center of the
struments under lagged reserve rtments in the United States, Spit&, PA., 1981, A note on the estimation of financial models, Mimeo. Spindt, P.A. and V. Tarhan, 1978, A model of large bank liquidity adjustment, Special Studies paper no. 121, Boatd of Govemon of the Federal Reserve System, Washin on? DC. Spindt, P.A. and V. Tarhan, 19g0, Liquidity structure adjustment behavior of Parge money center buka Journal of Money, Credit, and Ranking 12,19&208. Wallicb, H. and P. Keir, 197% Tba rok of operating guides in U.S. monetary policy: A historical review, Krcdit and Kapitrl, forthcoming.