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### Overview and definitions
- Reserve requirements impose that banks hold a quantity X of liquid assets (central bank reserves or securities) for every unit of deposit collected (or any pre-defined liability); X is the reserve requirement ratio.
- Reservable assets: the central bank reserves or the securities specified by a requirement.
- Reserve base: the deposits collected (or other pre-defined liabilities) used to calculate the requirement.
- Two historically distinct categories:
  - Cash-reserve requirements: minimum balances at the central bank (demand deposits at the central bank).
  - Securities-reserve requirements (also called liquid-asset requirements, liquidity ratios, or securities-reserve requirements): force banks to hold a proportion of assets (often government securities) as liquid assets not deposited at the central bank.
- Relation to modern policy:
  - The Basel III Liquidity Coverage Ratio (LCR) is described as a modern, more sophisticated form of securities-reserve requirements; it accepts central bank liabilities as liquid assets and includes a wider set of eligible reservable assets (notably some foreign currency debt, subject to haircuts). When excess reserves at the central bank equal zero, the LCR is equivalent to past securities-reserve requirements.

### Multiple functions and motives for reserve requirements
- Reserve requirements have been used for different objectives, sometimes simultaneously:
  - Banking regulation: force minimum liquid assets to withstand bank runs.
  - Monetary policy tool: constrain credit and control interest rates.
  - Tax: serve as a direct tax on banks; a Pigouvian tax on issuance of short-term deposits; tax on foreign deposits to discourage inflows or counter financial dollarization/currency risk.
  - “Financial repression” instrument: force banks to lend to government or defined sectors.
- Cash- and securities-reserve requirements are often jointly labeled “liquidity requirements” and their histories and theoretical effects are studied together.

### Historical evolution: from prudential tool to monetary policy instrument
- Cash- and securities-reserve requirements were first prudential and later used as monetary policy tools.
- U.S. experience:
  - Cash reserve requirements established in 1863 (National Bank Act) as regulation; became monetary tool in the 1930s.
  - By 1931 the Fed recognized reserve requirements’ de facto monetary role for controlling credit (Federal Reserve System, Annual Report 1931).
  - 1933 law made cash-reserve requirements adjustable; 1936–1937 reserve requirements became the main tool of Fed restrictive policy.
- International diffusion:
  - New Zealand and Sweden introduced similar techniques in 1936 and 1937.
- Securities-reserve requirements were largely abandoned in the 1980s due to complexity, circumvention, and central banks’ move away from quantitative instruments.
- Many central banks still use cash-reserve requirements for monetary policy implementation; securities-reserve requirements largely disappeared.

### Key purposes and rationale of securities-reserve requirements
- Principal rationale: prevent banks from circumventing restrictive monetary measures by selling government securities to obtain liquidity.
  - Example: Australia proposed a 25 percent ratio between liquid assets (including government securities) and total deposits in 1954 to make monetary policy more effective.
  - France used minimum portfolios of Treasury bills to prevent banks from offsetting rediscount ceilings.
- Alternative to securities-reserve requirements would be allowing government security prices to fall (raising yields), but central banks were often unwilling to act against governments.
- Postwar U.S.: large holdings of government securities by commercial banks (about 60 percent) led to proposals to “immobilize a portion of these assets.”

### Government financing and political economy
- Securities-reserve requirements sit at the crossroads of monetary and fiscal policy because government securities were the major type of liquid assets included.
- Quoted objectives:
  - Insulate government securities from restrictive monetary policy effects by requiring government securities as part of bank reserves.
  - Make possible more effective use of open market operations and discount rates “without seriously upsetting the Government securities market and unduly raising the interest cost on the public debt.”
- Liquidity requirements performed a dual role:
  - Controlled banks’ liquidity.
  - Secured financing to the government by forcing banks to hold government securities.
- Basel Committee note: Basel III includes sovereign or central bank debt securities issued in domestic currencies in the most liquid category; implication that sovereign debt issued by a government in default could be counted as liquid assets (ESRB (2015)).
- Political economy and redistribution:
  - Liquidity ratios were used to halt bank credit expansion and channel funds to budget deficits or subsidized sectors.
  - From the 1970s–1990s, shift to independent central banks and market-oriented tools reduced implicit taxes associated with “financial repression.”
- Complexity and measurement:
  - Reserve requirement effects depend on bindingness, combinations with other tools, and distributional/selective treatments; nominal ratio values alone do not identify monetary stance.

### Why securities-reserve requirements were abandoned
- Main reasons:
  - Effects on government financing (interaction with debt management).
  - Complexity and distributive effects across banks and sectors.
- Phased out by the 1980s as banks circumvented them and central banks favored market-based instruments.

### Model overview: liquidity ratios as monetary policy tools (Section III.A)
- Purpose: a simple theoretical model to clarify mechanisms through which liquidity requirements affected short-term money market rates.
- Key modeling assumption: securities can be pledged to borrow from the central bank and can also be used to fulfill securities reserve requirements; increasing securities reserve requirements reduces the stock of collateral banks can use to borrow at the central bank.
- Timing (trading-day timeline):
  I. Central bank injects liquidity.
  II. Interbank market trading session.
  III. After interbank market closes, banks experience a “late” deposit shock.
  IV. Banks access the central bank discount window: borrow overnight up to a limit at the normal discount rate; beyond the limit they can borrow at a penalty rate higher than the normal discount rate (the “hell rate”).
- Assumptions:
  - Required or excess balances are not remunerated.
  - Penalty rates (hell rates) exist historically and in modern discount windows.

### End-of-day liquidity constraint and discount-window collateral constraints
- End-of-day liquidity constraint for bank i:
  - R_i + B_i − ϵ_i + X_i + H_i ≥ K_i  (equation (1))
    - Definitions:
      - R_i: amount of central bank liquidity the bank holds before interbank market (period I).
      - B_i: amount of interbank borrowings.
      - ϵ_i: random deposit shock with mean 0 occurring after interbank market (period III).
      - X_i: amount borrowed at the discount window (normal rate).
      - H_i: amount borrowed at the hell (penalty) rate.
      - K_i: cash reserve requirement (end-of-day balance requirement).
- Collateral constraint and solutions:
  - Let C_i be the amount of collateral pledged to borrow at the normal discount rate.
  - X = max{0; min{C_i; K_i − (R_i + B_i − ϵ_i)}}  (equation (2))
  - H = max{0; K_i − (R_i + B_i − ϵ_i) − C_i}  (equation (3))
- Bank profit (before expectations):
  - Π_i = L r_L + r_s S_i − r_D (D_i − ϵ_i) − r_B B_i − r_H H_i − r_X X_i  (equation (4))
    - r_L, r_s, r_D, r_B, r_X, r_H are rates on loans, government securities, deposits, interbank loans, discount window loans, and hell rate respectively.
    - Simplification: assume r_D = r_B.

### Interbank market equilibrium and deposit shocks
- Deposit shock ϵ_i: random with mean 0, density g(.) and cumulative G(.).
- Expected profit expression (condensed form, from source):
  - E(Π_i) = L r_L + r_s S_i − r_D (D_i) − r_B B_i − r_H ∫_{R_i−K_i+B_i+C_i}^{∞} g(ϵ_i)(ϵ_i − (R_i − K_i + B_i + C_i)) dϵ_i − r_X ( ∫_{R_i−K_i+B_i}^{R_i−K_i+B_i+C_i} g(ϵ_i)(ϵ_i − (R_i − K_i + B_i)) dϵ_i + ∫_{R_i−K_i+B_i+C_i}^{∞} g(ϵ_i) C_i dϵ_i )  (equation (5))
- First-order condition for B_i:
  - ∂E(Π_i) / ∂B_i = 0  (equation (6))
- Symmetric-interbank-rate equilibrium:
  - r*_B = (1 − G(R − K + C)) r_H + (G(R − K + C) − G(R − K)) r_X  (equation (7))
- Relation to discount rate:
  - (r_X − r*_B) / r_X = ( (r_H / r_X − 1) (G(R − K + C) − 1) + G(R − K) )  (equation (8))

### Key mechanisms and intuition from the model
- Increasing securities-reserve requirements reduces collateral C available for discount-window borrowing:
  - Raises reliance on higher-cost borrowing (hell rate) or constrains access to the normal discount rate.
  - Alters banks’ interbank lending/borrowing decisions and thereby short-term money market rates.
- Comparative channels:
  - Cash-reserve requirements (k): increase demand for central bank liquidity, reduce excess liquidity in the money market, raise probability of higher-cost borrowing (Poole-type effect).
  - Securities-reserve requirements (τ): reduce collateral available for discount-window borrowing, create a quantity-rationing effect akin to rediscount ceilings.
- If the discount window is unlimited (rH = rX), securities-reserve requirements have no effect while cash-reserve requirements still affect rates.
- Nonlinearity: if R − K + C > P (where P is the support bound), interbank rate can be zero under uniform shock assumptions—liquidity requirements have stronger effects when excess reserves scarce.

### Securities-reserve requirements: model setup, equations and comparative statics
- Banks choose a share λS of deposits to invest in securities; λS depends on ρ (excess return between making a loan and the interbank rate).
- Securities usable either as collateral or to fulfill liquidity regulation, but not both.
- Collateral quantity:
  - C = D(λS − τ − k)
- Cash-reserve requirement:
  - K = kD  (equation (9))
- Payment shock distribution: uniform with support [−P; P], support linear in deposits:
  - P = pD  (equation (10))
  - P = −pD  (equation (11))  (source lists both; original model uses uniform support [−P; P])
- Interbank rate derivation:
  - r?B = rH P−R+K−C P−P + rX C P−P  (equation (12))
  - Rewritten:
    - r?B = rH p − R/D + k 2p + (rH − rX) (τ + k − λS) 2p  (equation (14))
- Assumption: rH > rX by definition.
- Main analytic result: increasing either k or τ raises the interbank rate (direct implication of equation (14)).

### Policy implications, interpretations and taxation view
- Securities-reserve requirements act as quantity rationing at the discount window (equivalent to rediscount ceilings).
- Advantages:
  - Prevent banks from selling government bonds to obtain liquidity that would be monetized by the central bank, helping to keep government-debt interest rates low.
- Use-case differentiation:
  - Securities-reserve requirements prevent conversion of government bonds into central bank liquidity during tightening, preserving low government bond yields.
  - Cash-reserve requirements can sterilize central bank interventions (e.g., FX interventions or domestic government bond market interventions).
- Relation to modern regulation:
  - Basel III LCR similarly reduces the stock of collateral banks can use to borrow from the central bank.
- Taxation interpretation:
  - Unremunerated reserve requirements impose an effective tax on banks (interest-free liabilities for the central bank), potentially used to contract lending, finance the government if central bank profits are transferred, or serve as a Pigouvian tax to discourage short-term liabilities.

### Empirical evidence and historical practice
- Prediction: tightening liquidity requirements (cash or securities) increases the interbank market rate, controlling for discount rate movements.
- German case (Bundesbank):
  - Period: 1955–1973, monthly data; local projection methods with three variables: interbank rate, discount rate, ratio of reserve requirements.
  - Finding: effect on interbank rate is immediate and long lasting; cash-reserve requirements impacted the money market.
  - Bundesbank used reserve requirements for sterilization of capital inflows (late 1959–early 1961); reserve requirements rose sharply and the discount rate rose with comparable magnitude.
- French case (Banque de France):
  - Period: 1960–1966; a single securities-reserve ratio (“coefficient de trésorerie”) varied de facto between 30 and 36 percent.
  - Model: 3-variable system (liquidity requirement measure, interbank rate, discount rate) with 2 lags each.
  - Finding: when securities-reserve requirements increased by 100 basis points, the interbank rate increased by about 10 basis points in the two months after the shock.
- Historical institutional lessons:
  - France shifted in 1967 from broad liquidity requirements to cash-only reserve requirements to reduce distortions in asset composition.
  - Sweden used liquidity ratios actively in the 1950s–1960s, with different ratios by bank size; mortgage bonds were allowed in liquid assets in 1969 to stimulate housing.
  - Bundesbank used reserve requirements to sterilize FX reserve accumulation under Bretton Woods, in some cases setting reserve ratios on liabilities to non-residents up to 100 percent.

### Theoretical implications and limits
- Reserve requirements can act as automatic stabilizers:
  - With required reserves equal to kD and in the Poole model when rH = rX:
    - r?B = rX (1 − G(R − kD))  (equation (15))
    - dr?B dD = g(R − kD) > 0  (equation (16))
  - Interpretation: as deposits expand, required reserves rise for fixed k, causing interbank rates to increase and dampening activity.
- Limits to the money-multiplier channel:
  - Requires fixed central bank liquidity and meaningful, non-avoidable reserve requirements.
  - Modern practices (accommodating liquidity to hit interest rate targets) and alternative regulatory constraints weaken the classic money-multiplier channel.

*Source: Section II of the supplied IMF working paper PDF content.*

### Section II provides the historical narrative of reserve requirement, section III develops the model

### II. Cash and Securities-Reserve Requirements in History

### Overview and definitions
- Reserve requirements impose that banks hold a quantity X of liquid assets (central bank reserves or securities) for every unit of deposit collected (or any pre-defined liability); X is the reserve requirement ratio.
- Reservable assets: the central bank reserves or the securities specified by a requirement.
- Reserve base: the deposits collected (or other pre-defined liabilities) used to calculate the requirement.
- Two historically distinct categories:
  - Cash-reserve requirements: minimum balances at the central bank (demand deposits at the central bank).
  - Securities-reserve requirements (also called liquid-asset requirements, liquidity ratios, or securities-reserve requirements): force banks to hold a proportion of assets (often government securities) as liquid assets not deposited at the central bank.
- Relation to modern policy:
  - The Basel III Liquidity Coverage Ratio (LCR) is described as a modern, more sophisticated form of securities-reserve requirements; it accepts central bank liabilities as liquid assets and includes a wider set of eligible reservable assets (notably some foreign currency debt, subject to haircuts). When excess reserves at the central bank equal zero, the LCR is equivalent to past securities-reserve requirements.

### Multiple functions and motives for reserve requirements
- Reserve requirements have been used for different objectives, sometimes simultaneously:
  - Banking regulation: force minimum liquid assets to withstand bank runs (Feinman (1993), Carlson (2015)).
  - Monetary policy tool: constrain credit and control interest rates (control demand for central bank money or stabilize interest rates) (Huberto M. Ennis and Todd Keister (2008)).
  - Tax: serve as a direct tax on banks (Romer (1985)); a Pigouvian tax on issuance of short-term deposits (Kashyap and Stein (2012)); tax on foreign deposits to discourage inflows or fare against financial dollarization/currency risk.
  - “Financial repression” instrument: force banks to lend to government or defined sectors (De Kock (1974), Jonung (1993), Reinhart and Sbrancia (2015), Monnet (2018)).
- Reserve requirements are complex instruments whose design and use vary substantially across time and countries.
- Cash- and securities-reserve requirements are often jointly labeled “liquidity requirements” and their histories and theoretical effects are studied together.

### Historical evolution: from prudential tool to monetary policy instrument
- Both cash and securities reserve requirements were first introduced as prudential regulatory instruments and later treated as monetary policy tools.
- Cash-reserve requirements in some countries (notably the U.S. and Germany) were the principal instrument; in many other countries securities-reserve requirements were used, sometimes in combination with cash-reserve requirements.
- Securities-reserve requirements were largely abandoned in the 1980s due to complexity, circumvention by banks, and central banks’ move away from quantitative instruments (Bindseil (2004), Bisignano (1996), Jonung (1993), Monnet (2018), Borio (1997)).
- Today, many central banks still use cash-reserve requirements for monetary policy implementation (O’Brien (2007), Gray (2011)); securities-reserve requirements have largely disappeared from the standard central bank toolbox.

### A. The birth of liquidity requirements as a monetary policy tool: U.S. cash requirements and international influence
- De Kock’s Central Banking editions document the shift:
  - 1st edition (1939) treated changes in minimum cash reserves as a recent and important addition, noting first introduction in the United States in 1933, amendment in 1935, and first use in August 1936.
  - De Kock anticipated wider adoption: “this method of changes in reserve requirements will probably tend to be more widely adopted and further developed” (De Kock (1939), p. 267).
- U.S. history:
  - Cash reserve requirements had a long history in the U.S. as a banking regulation tool (established in 1863 with the National Bank Act) before becoming a monetary policy tool in the 1930s.
  - Between 1913 and 1933 the Fed system kept a fixed cash-reserve requirement for banking regulation only.
  - By 1931 Fed officials recognized reserve requirements’ de facto monetary role: “The committee takes the position that it is no longer the primary function of legal reserve requirements to assure or preserve the liquidity of the individual member bank” and “The most important function served by member bank reserve requirements is the control of credit. [...] It is the function of reserve requirements to restrain such overexpansion by making it necessary for banks to provide for additional reserves before they expand their credit.” (Federal Reserve System, Annual Report 1931).
  - 1933: law made cash-reserve requirements adjustable to control credit; in 1936–1937 reserve requirements became the main tool of Fed restrictive policy (Friedman and Schwartz (1963)).
- International diffusion:
  - New Zealand and Sweden introduced similar techniques in 1936 and 1937, following the U.S. innovation.
  - The use of cash-reserve requirements spread worldwide in the 1930s and 1940s as countries implemented banking regulations and expanded monetary policy instruments.
- Preconditions:
  - The U.S. moved first because it had the most developed banking regulation dating to the mid-19th century; most other countries lacked such regulation before the mid-1930s or WWII (banks were registered like other companies and not constrained by capital or liquidity rules).

### B. Cash-reserve requirements vs. securities-reserve requirements (liquid-asset requirements)
- By 1974 De Kock’s book expanded reserve requirements into two types:
  - Cash-reserve requirement: demand deposits at the central bank as a proportion of some or total assets/liabilities.
  - Liquid-asset requirement: fixed proportion of total assets must be held in liquid assets (definition varying across countries/periods).
- Other surveys also distinguished these two instruments, using terms such as “liquidity ratios,” “securities reserve requirements,” or “liquid-asset requirement” (Fousek (1957), Goode and Thorn (1959), EEC (1962, 1972), Tamagna (1963), Thurow (1971), Hodgman (1973), OECD (1975)).
- Common perceived effect:
  - Both were seen as forcing banks to invest a proportion of assets in legally defined assets and thus as limiting the expansion of bank credit and money supply.
  - Quote: “Reserve requirements limit the total expansion of bank credit and the secondary expansion of bank deposits that can occur on the basis of any primary increase in deposits. [...] Reserves in forms other than cash deposits with the central bank can also serve the purpose of limiting the expansion of bank credit and the money supply. If the reserves take the form of government bonds or other securities than must be obtained from the central bank, their credit-limiting function is identical with that of cash reserves.” (Goode and Thorn, 1959, p. 10–13)
- Distinctive effects of securities-reserve requirements were also acknowledged by some authors and are discussed below.

### C. Key purposes and rationale of securities-reserve requirements
- Principal rationale: prevent banks from circumventing restrictive monetary measures by selling government securities to obtain liquidity.
  - Explicit formulation by central banks and commentators: banks holding large amounts of government securities “may be able to obtain additional reserves” by selling them (Fousek (1957), p. 55).
  - Securities-reserve requirements were used to avoid asset substitution in banks’ portfolios that would undermine cash-reserve requirements.
- Empirical examples:
  - Australia: selling of government securities by commercial banks nullified the restraining effect of cash-reserve requirements; in 1954 the central bank proposed a ratio of 25 percent between liquid assets (including government securities) and total deposits to make monetary policy more effective (Fousek (1957), p. 58).
  - France: liquidity ratio forcing banks to hold a minimum portfolio of Treasury bills prevented banks from redeploying Treasury bills in ways that would offset rediscount ceilings: “The fixing of rediscount ceilings would have lost its point if the banks, disposing as they did at the end of the war of a large portfolio of Treasury bills, had been left free to rediscount them with the central bank or not to renew them on their maturity. The banks were therefore called on at the same time to retain a minimum portfolio of Treasury bills. The imposition of ‘floors’ (‘planchers’) for government paper, [...] is an automatic restraint on the volume of loans the banks can make to their customers.” (EEC (1962), p. 121)
- Alternative to securities-reserve requirements would be allowing government security prices to fall (raising yields), but central banks were often unwilling to act against governments.
- Postwar U.S. observation: large holdings of government securities by commercial banks (about 60 percent) permitted potential expansion of credit via sales of securities; securities-reserve requirements were proposed to “immobilize a portion of these assets” to prevent their use in supporting credit expansion (Burkhead (1947); Federal Reserve Bulletin, January 1948).

### D. The U.S. debate on securities-reserve requirements
- The U.S., alongside West Germany, relied extensively on cash-reserve requirements rather than securities-reserve requirements.
- Proposals to introduce securities-reserve requirements in the U.S. occurred multiple times:
  - First academic proposals in 1940 (Riddle and Reierson (1946)).
  - Endorsements by Fed officials in 1945 and 1948 under names such as “special” or “secondary” reserve requirement (Federal Reserve Bulletin, January 1948; Willis (1948); Romer and Romer (1993); Meltzer (2003) p. 645–650), but Congress rejected them.
  - Renewed proposals in the late 1950s, motivated by European central bank experience with liquidity ratios (Fousek (1957), Ascheim (1958), McLeod (1959)).
- Purpose expressed in U.S. debates:
  - To define a set of liquid assets (Treasury bills, certificates or notes, balances with Federal Reserve Banks, cash, etc.) and impose a requirement of such liquid assets as a percentage of bank deposits to control inflation via credit restrictions.
  - Federal Reserve Bulletin (January 1948) summarized: “In order to provide a more effective means of restraining inflationary expansion of bank credit, the Board of Governors of the Federal Reserve System proposes that Congress pass legislation granting the System’s Federal Open Market Committee temporary authority to impose gradually as conditions may warrant a requirement that all commercial banks hold a special reserve.” (Federal Reserve Bulletin, January 1948, p. 14)
  - The special requirement’s objective: “This special requirement would make it possible for the Federal Reserve System to immobilize a portion of these assets. This immobilization, however, would be only for the purpose of preventing their use for the purpose of obtaining additional reserves to support expansion of credit to private borrowers.” (ibid)
- Context: heavy bank holdings of government securities (about 60 percent) during and after WWII; securities-reserve requirements seen as reconciling monetary management and debt management policies (Miller (1950)) and complementing other monetary restraint tools whose effectiveness was undermined by bank sales of government securities.

### E. Why securities-reserve requirements were abandoned
- Two main reasons highlighted:
  - The effects of these tools on government financing.
  - Their complexity and distributive effects.
- Historical note: securities-reserve requirements were phased out by the 1980s as banks found ways to circumvent them, and central banks moved away from quantitative instruments (Bindseil (2004), Bisignano (1996), Jonung (1993), Monnet (2018), Borio (1997)).

*Source: Section II of the supplied IMF working paper PDF content.*

### 1.   Government Financing

### 1.   Government Financing

### Role of Securities-Reserve Requirements and Interaction with Monetary and Fiscal Policy
- Historical debates in the U.S. considered securities-reserve requirements to be at the crossroads of monetary policy and fiscal policy because government securities were the major type of liquid assets to be included in liquidity requirements.
- Quoted rationales:
  - “the view has been expressed that it would be both feasible and desirable to insulate government securities, in whole or in part, from the impact of restrictive monetary policies on the private credit market. One proposal commonly mentioned in this connection is to require government securities as part of the reserve to be held by commercial banks against their deposits, supplementary to the prevailing cash-reserve requirements” (Ascheim (1958))
  - “From the monetary point of view the principal purpose of the proposed new requirement is to make possible the more effective use of the existing instruments in offsetting changes in bank reserves – particularly open market operations and discount rates – without seriously upsetting the Government securities market and unduly raising the interest cost on the public debt.”(Federal Reserve Bulletin, January 1948, p. 18 ).
- Post 2007–2008 crisis parallels with post-WWII: large volume of government securities on banks’ balance sheets and central bank commitments to purchase government bonds and keep interest rates low.
- Liquidity requirements performed a dual role:
  - Controlled banks’ liquidity.
  - Secured financing to the government (by forcing banks to hold a certain amount of government securities).
- Basel Committee treatment relevant to modern debate:
  - Basel Committee includes in the most liquid category: “sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the country in which the liquidity risk is being taken or in the bank’s home country” BCBS (2013).
  - Implication: sovereign debt issued by a government in default could be counted as liquid assets (ESRB (2015)).

### Political Economy and Redistributional Effects
- Reserve requirements—both cash and securities—served multiple roles beyond monetary policy (banking regulation, inflation combat, banking stability, allocation to priority sectors, capital controls).
- Historical usage:
  - European countries used ratios to halt excessive bank credit expansion and to channel bank funds into financing budget deficits (Fousek (1957), p. 57).
  - Some liquidity ratios legally defined securities of subsidized sectors (e.g., housing) as liquid assets, creating selective/distributive monetary policy.
- Evolution:
  - 1970s–1990s: shift to independent central banks and market-oriented tools (open market operations), phasing out implicit taxes associated with “financial repression” (Reinhart and Sbrancia (2015)); Bindseil (2004) notes cash reserve requirements continued at much lower levels to stabilize money market rate.
- Cross-country variety and complexity:
  - French, Swedish, and German cases illustrate different interactions: public debt financing, integration into monetary instruments aimed at fighting inflation, differentiation by bank size, sterilization of capital inflows and capital controls.
  - The nominal value of different ratios (reserve requirement, discount ceilings, credit ceilings) is not informative alone about the monetary policy stance because:
    - Ratios evolve to remain binding as bank balance-sheet composition changes.
    - The strength of ratios depends on how they are combined with other tools (discount rate, credit growth ceilings).
- Because liquidity requirements were complex and combined distributive objectives, it is difficult to estimate their macroeconomic effects; lacking a simple empirical framework, there is an argument for better theory to identify channels and combinations with other instruments.

### Complexity of Tools and Implications for Measurement and Policy
- Reserve requirements had to be binding to function as effective monetary policy tools; they had to adapt to banking system characteristics and other policy instruments.
- Two constraints created complexity:
  - Effectiveness constraint (must be binding given banking sector features).
  - Selectivity constraint (allowing advantageous treatment for priority sectors).
- Consequence: impossible to measure monetary policy stance by simply observing ratio levels; narrative and composite-instrument approaches (Romer and Romer (1993), Monnet (2014), Aikman et al. (2016)) cannot isolate separate effects of each quantitative instrument.
- Empirical difficulty likely contributed to phasing out such instruments in favor of market-oriented tools.

### III.A Model of Liquidity Ratios as Monetary Policy Tools — Overview
- Purpose: use a simple theoretical model to clarify mechanisms through which liquidity requirements affected short-term money market rates.
- Key modeling assumption: securities can be pledged to borrow from the central bank and can also be used to fulfill securities reserve requirements; increasing securities reserve requirements reduces the stock of collateral banks can use to borrow at the central bank.
- Relation to existing literature:
  - Draws on Ennis and Keister (2008), Bech and Keister (2013), Vari (2019).
  - Authors claim novelty in introducing liquidity regulation and collateral constraints in a model of the money market (Bech and Keister (2013) modeled liquidity regulation without collateral constraints).
- Relevance to Basel III LCR: includes both safe securities and deposits at the central bank; channels in the model are potentially relevant to LCR effects.

### Model Structure and Timing
- Trading-day timeline:
  I. Central bank injects liquidity.
  II. Interbank market trading session.
  III. After interbank market closes, banks experience a “late” deposit shock.
  IV. Banks access the central bank discount window: borrow overnight up to a limit at the normal discount rate; beyond the limit they can borrow at a penalty rate higher than the normal discount rate (the “hell rate”).
- Assumptions:
  - Required or excess balances of banks are not remunerated (consistent with post-war practice).
  - Penalty rates (hell rates) existed historically and persist in features of modern discount windows.

- Diagram 1. Timing of the Model (text description in source):
  - I CB injects liquidity
  - II Interbank market
  - III Deposit shock
  - IV Discount/Hell rate window

### End-of-Day Reserve Requirement Constraint (Period IV)
- End-of-day liquidity constraint for bank i:
  - R_i + B_i − ϵ_i + X_i + H_i ≥ K_i (equation (1))
    - R_i: amount of central bank liquidity the bank holds before interbank market (period I).
    - B_i: amount of interbank borrowings.
    - ϵ_i: random deposit shock with mean 0 occurring after interbank market (period III).
    - X_i: amount borrowed at the discount window (normal rate).
    - H_i: amount borrowed at the hell (penalty) rate.
    - K_i: cash reserve requirement (end-of-day balance requirement).
- Cash reserve requirements impose that the end-of-day balance of bank “i” is greater than some number K_i.
- If no reserve requirements, bank would need to ensure non-negative central bank account; otherwise effectively borrowing from monetary authority.

### Discount Window Borrowing and Collateral Constraints (Period IV)
- Banks require collateral to borrow at the normal discount window rate; if insufficient collateral, they must borrow at the hell rate.
- Let C_i be the amount of collateral pledged to borrow at the normal discount rate.
- Solutions for discount-window and hell-rate borrowing:
  - X = max{0; min{C_i; K_i − (R_i + B_i − ϵ_i)}} (equation (2))
  - H = max{0; K_i − (R_i + B_i − ϵ_i) − C_i} (equation (3))
- Profit function for bank i (before expectations):
  - Π_i = L r_L + r_s S_i − r_D (D_i − ϵ_i) − r_B B_i − r_H H_i − r_X X_i (equation (4))
    - r_L, r_s, r_D, r_B, r_X, r_H are rates on loans, government securities, deposits, interbank loans, discount window loans, and hell rate respectively.
    - First three rates are market rates; last two are set by the central bank.
    - Simplification: assume r_D = r_B.

### Period III: Deposit Shock and Profit Variability
- Deposit shock ϵ_i is a random variable with mean 0, density g(.) and cumulative G(.).
- The payment shock captures late payment orders banks cannot perfectly predict and cannot fully offset via interbank trading.

### Period II: Profit Maximization and Interbank Market Equilibrium
- Expected profit combining prior relations (equation (5)):
  - E(Π_i) = L r_L + r_s S_i − r_D (D_i) − r_B B_i − r_H ∫_{R_i−K_i+B_i+C_i}^{∞} g(ϵ_i)(ϵ_i − (R_i − K_i + B_i + C_i)) dϵ_i − r_X ( ∫_{R_i−K_i+B_i}^{R_i−K_i+B_i+C_i} g(ϵ_i)(ϵ_i − (R_i − K_i + B_i)) dϵ_i + ∫_{R_i−K_i+B_i+C_i}^{∞} g(ϵ_i) C_i dϵ_i )
    - g(.) is the density function of ϵ_i.
- First-order condition for profit maximization with respect to interbank loans B_i:
  - ∂E(Π_i) / ∂B_i = 0 (equation (6))
- Under symmetry across banks, interbank rate equilibrium (equation (7)):
  - r*_B = (1 − G(R − K + C)) r_H + (G(R − K + C) − G(R − K)) r_X
- Expression relating the interbank rate to the discount rate (equation (8)):
  - (r_X − r*_B) / r_X = ( (r_H / r_X − 1) (G(R − K + C) − 1) + G(R − K) )

### Key Mechanisms and Intuition
- Increasing securities-reserve requirements reduces collateral C available for discount-window borrowing, which:
  - Raises reliance on higher-cost borrowing (hell rate) or constrains access to the normal discount rate.
  - Affects banks’ interbank lending/borrowing decisions and thereby short-term money market rates.
- The model captures how liquidity regulation and collateral constraints transmit to interbank rates via the distribution of end-of-day shocks and the availability of pledged collateral.

*Source: wpiea2019176-print-pdf - 1.   Government Financing*

### 7.   Securities Reserve Requirements

### 7.   Securities Reserve Requirements

### Model setup and key equations
- Banks fund securities and loans with deposits and choose a share λS of deposits to invest in securities; λS is a function of ρ (the excess return between making a loan and the interbank rate) and ρ is taken as given.
- Securities can be used either to:
  - be posted as collateral to borrow at the central bank discount window, or
  - fulfill liquidity regulation,
  - but not both at the same time.
- Quantity of collateral available at the discount window:
  - C = D(λS − τ − k), where τ is the securities-reserve requirement and k the cash-reserve requirement.
- Cash-reserve requirement defined as a fraction k of deposits:
  - K = kD (equation (9)).
- Payment shock distribution: G is the cdf of a uniform distribution with support [−P; P], and support is linear in deposits:
  - P = pD (equation (10))
  - P = −pD (equation (11))
- Interbank rate in the model (as derived):
  - r?B = rH P−R+K−C P−P + rX C P−P (equation (12))
  - Rewritten using (10) and (11):
    - r?B = rH p − R/D + k 2p + (rH − rX) (τ + k − λS) 2p (equation (14))
- Assumption: rH > rX by definition.

### Mechanisms and comparative effects of k and τ
- Main analytic result:
  - An increase in either k or τ leads to a rise of the interbank rate (direct implication of equation (14)).
- Channels:
  - Cash-reserve requirements (k):
    - Increase directly demand for central bank liquidity to comply with required reserves, reduce excess liquidity in the money market, and thereby raise the probability that banks borrow at higher market rates — a Poole-type effect.
  - Securities-reserve requirements (τ):
    - Reduce the stock of liquid assets banks can use as collateral at the discount window (de facto access restriction), leading to higher borrowing rates — a quantity-rationing effect akin to rediscount ceilings.
- Equivalence and differences:
  - Cash and securities reserve requirements have similar effects on interest rates but operate through different channels (liquidity demand vs. collateral-availability/quantity rationing).
  - In a world with unlimited discount window access (rH = rX), securities-reserve requirements have no effect, while cash-reserve requirements still affect rates.
- Nonlinearity / boundary condition:
  - If R − K + C is greater than P, the interbank rate is equal to zero due to the uniform distribution assumption (G(N) = 1 when N > P). Thus, liquidity requirements have stronger effects when excess reserves are scarce.

### Policy implications and interpretations
- Securities-reserve requirements act as quantity rationing at the discount window (equivalent to rediscount ceilings): they limit de facto the maximum a bank can borrow by reducing eligible collateral.
- Advantages of securities-reserve requirements:
  - Prevent banks from selling government bonds to obtain liquidity that would be monetized by the central bank (avoids expanding central bank liquidity and keeps government-debt interest rates low).
- Use-cases differentiation:
  - Securities-reserve requirements can prevent banks from converting government bonds into central bank liquidity during tightening phases, preserving low government bond yields.
  - Cash-reserve requirements can be used to sterilize central bank interventions (e.g., foreign exchange interventions, or interventions in the domestic government bond market).
- Relation to modern regulation:
  - Contemporary regulations (e.g., Basel III) similarly reduce the stock of collateral banks can use to borrow from the central bank.
- Taxation interpretation:
  - Unremunerated reserve requirements impose an effective tax on banks (interest-free liabilities for the central bank), potentially used to:
    - contract lending,
    - finance the government if central bank profits are transferred,
    - serve as a Pigouvian tax to discourage short-term liabilities.

### Empirical tests and historical evidence
- Prediction tested: Tightening liquidity requirements (cash or securities) increases the interbank market rate, controlling for central bank discount rate movements.
- German case (Bundesbank):
  - Period: 1955–1973, monthly data.
  - Method: local projection methods with three variables: interbank rate, discount rate, ratio of reserve requirements.
  - Finding: Effect on the interbank rate is immediate and long lasting; cash-reserve requirements impacted the money market (Figure 1 referenced).
  - Bundesbank also used reserve requirements for sterilization of capital inflows (late 1959–early 1961) — reserve requirements rose sharply and the discount rate rose with comparable magnitude.
- French case (Banque de France):
  - Period: 1960–1966, when a single securities-reserve ratio (coefficient de trésorerie) was used and modified frequently.
  - Measure: change in the liquidity ratio (which varied de facto between 30 and 36 percent).
  - Model: 3-variable system (liquidity requirement measure, interbank rate, Banque de France discount rate) with 2 lags each (AIC criterion).
  - Finding: When securities-reserve requirements increased by 100 basis points, the interbank rate increased by about 10 basis points in the two months after the shock (Figure 2 referenced).

### Historical practice and institutional lessons
- France:
  - Post-WWII liquidity ratio required banks to maintain 60 percent between liquid assets and short-term liabilities; the ratio itself was not adjusted, but the definition of liquid assets evolved and was used for monetary policy.
  - Development of “Treasury floor” (planchers) from 1948 forced holdings of government bonds as proportion of deposits; later the “coefficient de trésorerie” broadened the numerator and denominator to give monetary authorities better control.
  - Shift in 1967 from broad liquidity requirements to cash-only reserve requirements to reduce distortions in asset composition.
- Sweden:
  - Early adoption of liquidity ratios; by the 1950s–1960s the liquidity ratio was an active countercyclical monetary instrument (ratios differed across bank size categories).
  - In 1969 mortgage bonds were allowed in liquid assets to stimulate housing investment.
- Bundesbank and sterilization under Bretton Woods:
  - Central bank sterilization of FX reserves could be implemented either via open-market operations (sell domestic assets) or by increasing reserve requirements.
  - Increasing reserve requirements kept excess reserves unchanged and maintained interest rates while accommodating FX reserve accumulation.
  - Reserve requirements were used in 1959–1961 in Germany to sterilize capital inflows instead of revaluation; in some cases reserve ratios for liabilities to non-residents could be set up to 100 percent (Deutsche Bundesbank Act citation).
- Reserve requirements as an instrument:
  - Historically used both as monetary policy instruments (to affect interbank rates and credit) and as fiscal or prudential tools (sterilization, discouraging foreign liabilities, targeting asset composition).

### Additional theoretical implications
- Reserve requirements as automatic stabilizers:
  - With required reserves equal to kD, and in the Poole model when rH = rX, interbank rate:
    - r?B = rX (1 − G(R − kD)) (equation (15))
  - Hence:
    - dr?B dD = g(R − kD) > 0 (equation (16))
  - Interpretation: As deposits (D) expand, required reserves rise for fixed k, causing interbank rates to increase and dampening activity — a stabilizing mechanism.
- Limits to the money-multiplier channel:
  - The multiplier mechanism requires fixed central bank liquidity and meaningful reserve requirements that cannot be easily avoided.
  - Modern central bank practices (accommodating liquidity to hit interest rate targets) and alternative liabilities or regulatory constraints (capital requirements) weaken the classic money-multiplier channel.

*Source: wpiea2019176-print-pdf — 7.   Securities Reserve Requirements.*

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### wpiea2019176-print-pdf - References

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*Source: wpiea2019176-print-pdf - References*

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