An Analysis on the Incidence of Excess Reserves

AN ANALYSIS ON THE INCIDENCE OF EXCESS RESERVES:

CASE OF THE PHILIPPINES

A Thesis Presented to the

Philippine Economics Society

By

Polintan, Felipe T. Jr.

Poquiz, Jasmin S.

Simon, Justin G.

October 2013

ABSTRACT

Excess Reserves are still an important part of the central banks’ monetary instrument via reserve requirement and open market operation. Hence this paper provides an analysis on the behavior of excess reserves for policy implications and its impact to the financial system. It could also help the thrift banks to evaluate their reserve management. This study focused on the behavior of thrift banks’ excess reserves from 1990 to 2010.

Primarily, the reason why banks hold excess reserves is to provide a buffer against uncertainty. Since the timeline covers two crises that affected the Philippines, the Asian and Global Financial Crisis, one of the objectives of this paper is to know how thrift banks responded to the credit crunches. Additionally, interest rates specifically 91-day Treasury Bills rate was used as an opportunity cost of holding excess reserves. Finally, the researchers used demand deposit to further observe banks’ level of excess reserves as adapted in the model of Dow (2001).

A regression analysis was used to test the short-run effects of excess reserves against the three explanatory variables. Demand deposit and crisis are presumed to have a positive relationship, while interest rates to be negatively correlated with excess reserves. The results confirm the hypothesis of demand deposit. However, the same was not true in the case of interest rate. This paper also found different banking behaviors from the two crises.

Extensive studies about excess reserves in the Philippines are strongly suggested since there had been lack of support and evidences noticed in the case of this country. The researchers suggest that the central bank would make data on excess reserves on daily basis to be publicly available since most of the literature provides a detailed study on that. Furthermore, this could help banks to determine whether they are maximizing profitability or having enough buffers in case of shocks.

Key words: Excess Reserves, Demand Deposits, 91-Day Treasury Bills Rate, Asian Financial Crisis, Global Financial Crisis

TABLE OF CONTENTS

Page

Title1

Abstract2

Table of Contents3

List of Tables4

List of Figures4

CHAPTER 1 INTRODUCTION5

Key Issues/Trends5

Objectives of the Study8

Significance of the Study8

CHAPTER 2 REVIEW OF RELATED LITERATURE9

Synthesis23

Simulacrum24

CHAPTER 3RESEARCH METHODS25

Research Design25 Data Gathering Procedure 26

Data Analysis26

CHAPTER 4 DATA PRESENTATION AND ANALYSIS29

Data Presentation29

Results and Findings30

CHAPTER 5CONCLUSIONS AND RECOMMENDATIONS38

Conclusions38

Recommendations41

REFERENCES43

APPENDICES46

ABOUT THE AUTHORS55

LIST OF TABLES

Table 1: Regression Analysis25

Table 2: Ramsey RESET43

LIST OF FIGURES

Figure 1: Simulacrum20

Figure 2: Scatterplot42

An Analysis on the Incidence of Excess Reserves: Case of the Philippines

Felipe T. Polintan Jr., Jasmin S. Poquiz, Justin G. Simon

Introduction

Financial crises have always been a great threat to different economies. Two of the most recent crises faced by the Philippines were the Asian Financial Crisis and Global Financial Crisis. According to Asian Development Bank (ADB), Asian Financial Crisis of 1997 had significant detrimental effects on a number of neighboring countries of the Philippines and other economies that caused a slow growth performance. Moreover, according to Aslam (2012), one of the major factors that contributed to the Asian Financial Crisis was the inflow of Foreign Portfolio Investment (FPI) from different countries in stocks and great amount of short term intra-bank loans. When these portfolio investments penetrate the banking system, it gives pressure to the domestic expenditure and increases the current account deficit. And its outflow can decrease asset prices, interest rates, lower the value of local currency and it results in liquidity problems in the banking sector.

Another point of view given by Corsettiet. al., (1999), was that the Asian Financial Crisis rooted mainly from the moral hazard problem of different industries. For some institutions, it was seemed to be rampant because government gave guarantees to private projects like direct subsidies and supporting policies that directed credit to favor the firms and other industries. This was because the government would like to induce higher output from firms to have high rates of economic growth. These supports given by the government made the firms to be more complacent thus overlooked the costs and riskiness of investment projects. The core implication of this problem was that a pressure to profitability does not encourage institutions to be more cautious in lending and to follow financial strategies reducing the overall riskiness of their portfolios.

On the other hand, the Global Financial Crisis was caused by housing bubble in United States which peaked in 2007. It was caused by the values of securities tied to U.S. real estate pricing to fall, damaging financial institutions worldwide (Shahrokhi, 2011). Also, Cook (2011) strongly argued that this sub-prime crisis was actually the greatest money and credit excess in the history of the world.

Gorton (2010) however argued that that there was banking panic on August 2007. Depositors rushed to banks and demanded their money back. But banks were not able to suffice these demands immediately since they have lent the money out already or they had it for long-term bonds. To honor these demands, banks must sell assets but only the Federal Reserve had the capability to buy the assets. It only proved that housing bubble led banks to hold illiquid assets thus they were not able to suffice the demands of the depositors.

In addition, Aslam (2012) stated that the U.S. economic crisis was consisted by the boom-bust-cycles in the stock market, housing market and financial market. The crisis in the stock market spilled over not only to technology related industries but also in automobile, electronics and other manufacturers. In the late 2007 the subprime mortgage defaults contributed partly to the increase in unemployment in the United States. The emergence of cheap money and low interest rates worsen the sub-prime crisis. Low interest rates attracted property sectors to increase the demand for credit. Property loans of mortgage loans were repackaged and sold in form of securities. The main purpose of securitization of loans was to increase bank liquidity in order to meet the demand from the household sector.

One of the most remarkable factors in the banking system that had been noticed and talked about by a lot of Western researchers was the excess reserves. Notice that in the global financial crisis, the United States significantly increased their level of excess reserves. Keister and McAndrews, (2009) pointed out that in the U.S., their excess reserves rose from $45 billion to $900 billion by January 2009. A lot of analysts saw the surge in excess reserves as an alarming development in the banking system. This simply emphasized that during crisis, instead banks lend funds out to the households, firms and other banks, and they were hoarding it and put it in their reserves. Other observers saw the hoarding of excess reserves as a sign that the mechanisms implemented by the Federal Reserve during the crisis have been ineffective. Instead of restoring the flow of credits, the money that the Fed has lent to banks since September 2008 is in the banks’ reserves. In addition, it was also been identified by Edlin and Jaffee (2009) that excess reserves were the problem behind the continuing credit crunch.

Talasli (2010) stated that uncertainty increases the level of excess reserves. Since the Philippines has also been affected by the two great uncertainties: Asian Financial Crisis (Nagayasu, 2001) and financial crisis of 2007 (Rodgers et al., 2012), this paper examined the behavior of thrift banks on how they manage their excess reserves during the crises and in normal times.

Moreover, this paper adapted the model of Dow (2001) and included only the demand deposit and interest rate as an opportunity cost of holding excess reserves to give precise analysis on the behavior of thrift banks toward their reserve management. The researchers however excluded the other explanatory variables from Dow such as the required reserve balances and the demand factor observed by the open market desk in the U.S. since they were not part of this study.

Knowing how these factors: demand deposits, opportunity cost of holding excess reserves (interest rates) and uncertainties (Asian and Global Financial Crises) affect the level of excess reserves, can help the thrift banks to evaluate their reserve management as well as the Bangko Sentral ng Pilipinas in implementing monetary policies. This could also help future researches about reserves since this will be the first study of excess reserves in the Philippine setting.

Furthermore, it is important to take note and not to be confused that this paper only discussed the fractional reserves of banks and not the gross international reserves of the country as a whole, which includes foreign currencies and gold reserves. The data on excess reserves was confined only from thrift banks which exclude other types of banks such as commercial and universal banks. For the reason that the current literature on excess reserves was more focused on big depository institutions (DIs) such as the commercial universal banks, this paper however wanted to explore the situation of small DIs such as thrift banks because thrift banks have a relatively small capital and therefore more prone uncertainty risks.

Review of Related Literature

Bank Reserves

Under the fractional reserve system, each deposit made to the depository institutions are subjected to a legal requirement which individual banks have to comply with. Bank reserves are funds which are kept by banks, in order to meet the central bank’s statutory reserve requirement. Similar to the United States, these reserves can be held either as cash balances in individual banks’ vaults or deposits in the central bank. Reserves subject to the legal requirement are known as required while the additional reserves are called excess (Taufemback et al., 2012). Management on the supply of reserve balances is important in the operation of U.S. monetary policy (Judson et al., 2011).

The main monetary instrument applicable for maintaining a level of reserve is the manipulation of the reserve requirements by the central bank. Faig et al., (2008) and Jalbert et al., (2010) both researchers justify the use of reserve requirements as a channel to regulate the money supply in order to stimulate the economy. Lown (2003) considers reserve requirement as “tax” on banks for holding reserves which are not interest earning. In this case, banks prefer to have low reserve requirements in order to free more funds for and invest them into earning assets.

In the banking literature, reserves have been considered as an instrument to manage the risk of facing uncertainty of withdrawals from depositors (Faig et al., 2008). In the case of extreme uncertainty, a central bank may opt to use reserve requirement to strengthen the health and stability of financial institutions during an economic downturn or crisis (Jalbert et al., 2010).

Excess Reserves

The Reserve Position Doctrine (RPD) as a monetary policy deals with the manipulation of the level of excess reserves via open market operations. Although most banks now are shifting away from RPD and adopting interest rate targeting, there is still an ample space in the textbooks about it which is popularly known as the money multiplier. In the European Central Bank (ECB), excess reserves are still used as the framework in their monetary policy (Bindseil et al., 2006).

Excess reserves are the incidental accumulation of liquid reserves held by banks. Although there are some banks which prefer to hold more reserves more than what is required to satisfy unexpected withdrawals (Agenor et al., 2004) from depositors or which we will consider as uncertainty. Whenever a bank fails to meet the legal requirement they are penalized by the central bank. To avoid overdraft or penalties on reserve deficiencies, banks wanted to hold more reserve balances. Likewise, more excess reserves provides less risk for bankruptcy in case of bank runs but it provides an opportunity cost of lower profits because of reduced loanable funds (Taufemback, 2012).

This was also supported by Ashcraft (2011) that excess reserves are held because either no bank can trade after payments shocks occur, payments shocks are withdrawn from the banking system, or there are autonomous shocks to the supply of reserves held by banks that the Fed does not fully offset. Reserve balances are used by banks to meet legal requirement and to settle payments, if they fall short on liquidity they may opt to borrow in the interbank market and lend excess, if they have any to other banks who are overdraft (Fullwiler, 2006).

According to Cargill (2006), banks hold excess reserves because of the fear of bank runs as learning from their experience in the Great Depression of 1930 – 1933. Also, there has been an excessive supply of reserve balance in the credit crunch of 2008 and it continued to be remarkably high as compared to previous levels (Judson et al., 2011). But contrary to the arguments above, banks minimize excess balances holdings as stated since they earn no interest (Demiralp, 2005). Dow (2001) stated that banks want to hold reserves to avoid overdraft or reserve deficiency penalties on their account at the central bank when facing uncertain flows of funds.

Demand Deposits

Dow (2001) used demand deposit in his model to determine the level of excess reserves. He stated that excess reserves have increased with the growth of deposits. Truly, the findings of his paper showed that an increase of deposit of $1 billion corresponds to an additional $3 million of excess reserves. Moreover, Lown et al., (2003) said that the possibility of reserve drains really depends on the demand deposit losses as well as for time deposits. They then concluded in their work that deposits were really used by banks to determine their reserve position.

Ogawa (2007) supported through his estimation results that deposits exerted a significantly positive effect on reserve holdings. However, he did not emphasized much on deposits rather more on the financial health of the banks and the interest rates set by the central bank.

Skeie (2008) added to the literature that through his model large withdrawals of demand deposits can exhaust banks’ excess reserves. Further, he also emphasized on demand deposits’ effect on banks’ liquidty and bank run. He stated in his study that the central bank creates a fiat currency that it uses to buy and sell goods and services at a fixed price. In his study he measured demand deposits in real terms and currency in circulation withdrawals rather than nominal terms of those that is based on the fiat currency. He used it to know how those variables affect excess reserves or liquidity that in turn cause bank runs and liquidity crises. He added that literature provides that bank runs are caused by withdrawals of demand deposits payable in real goods that exhausts in the banking system a fixed reserve of goods. The framework describes a traditional bank run in US and recently developing countries where it is based on currency in circulation withdrawals. In contrast, large withdrawals usually are in electronic payments of inside money without affecting a depletion of a scarce reserve from the banking system. Furthermore, Skeie (2008) included in his study that in a closed economy with no central bank intervention or in the absence of regulation and other policy influence, bank reserves are not exhausted from the banking system unless currency is withdrawn and stored outside of the system.

Skeie (2008) also included in his study that large withdrawals drain excess liquidity and liquidity reserves present in the banking system. He added that regardless of the trigger, depletion of fixed liquid real goods reserve present to be paid out from the system of banking is caused by excessive withdrawals. To provide to these short term payouts, long term investments have to inefficiently liquidate. Because of this inefficiency, all depositors will try to withdraw immediately knowing that bank will not be able to pay all future withdrawals. A bank run in a real deposits frameworkwill still happen even if the bank is fundamentally solvent for the reason that the liquidity structure of short term liabilities and long term assets are fragile.

Teles and Zhou (2005) added that retail sweep programs that reclassify demand deposits to savings account affect the exhaustion of reserve balances. He added that since 1994, banks reclassify back their demand deposit accounts when its low from their previous reclassification of demand deposits balances above a certain level. For these reason, the study found out that the portion reclassified in the demand deposits led to the avoidance of reserve requirements and holdings of reserves by banks. The study of Duca and VanHoose (2004) emphasized that the recent increasing swept demand deposit balances led to a weaker link between demand deposit and liquidity. In effect, their paper stated that adjustments in M1 would be optimal so that monetary policies can consider these swept balances and for banks to hold the optimal reserve requirements.