The Federal Reserve Board, worried about the financial health of the nation's banks and about lending cutbacks that are hurting the economy, yesterday reduced the amount of cash and other assets that banks are required to keep in reserve.
The decision to cut the reserve requirement by about one-quarter should add close to $900 million to bank and thrift institution profits next year. At the same time, it will increase the federal budget deficit by about $600 million, Fed officials said.
Under Fed rules, each financial institution that accepts deposits must set aside a certain portion as a reserve that is either kept on hand as cash in its vaults or held in a non-interest earning account at a regional Federal Reserve bank. Since reserves held in either form pay no interest, the reserve requirement directly reduces bank profits.
In announcing its move, the Fed said it expects banks will now be in a position to make more loans to businesses and consumers. The prospect of higher profits should also help lift the price of bank stocks, which as a group have been clobbered this year by large operating losses that have resulted from real estate loans gone sour.
"The board took action in response to mounting evidence that commercial banks have been tightening their standards ... for many types of loans," the Fed said in its announcement. "While much of this tightening has been welcome from a safety and soundness standpoint, it has in recent months begun to exert a contractionary influence on the economy."
While the reduction in reserve requirements may make it easier for creditworthy borrowers to get loans, it won't make those loans any cheaper. And Fed sources said yesterday the action on reserves makes it less likely that the central bank would take any additional steps to lower interest rates again before the end of the year.
Bush administration officials, some members of Congress and many financial analysts welcomed the action on reserve requirements.
"I thought the move today was a sensible step," said Michael Boskin, chairman of the president's Council of Economic Advisers.
"It is a positive move," declared Michael Darby, undersecretary of commerce for economic affairs. "There have been concerns about bank profitability, and this should help. It lowers reserve requirements on banks, which act largely as a tax on banks."
Reserves originally were required by state authorities to make sure banks had enough cash available to meet withdrawals by depositors. Now, their essential purpose is to provide a medium through which the Federal Reserve can influence interest rates and the availability of credit -- and therefore the course of the economy -- on a day-to-day basis.
While banks do not earn interest on their reserves, the Fed does, investing the funds in U.S. government securities. Thus, by reducing the required level of reserves, the Fed will trim its own profits by roughly $900 million each year -- profits that are turned over to the Treasury. With institutions likely to pay about one-third of their additional $900 million in profits in federal income tax, the net increase in the budget deficit would be about $600 million, Federal Reserve officials said.
The Fed action had an immediate impact on the value of bank stocks yesterday. Wells Fargo Bank finished up $3 at $55.12 1/2, Republic Bank of New York surged $2.37 1/2 to $48.25, Bankers Trust advanced $2.37 1/2 to $41.37 1/2, while full dollar-a-share gains were realized by BankAmerica, Mellon Bank, Bank of New York, Citicorp, Manufacturers Hanover, Morgan Guaranty, First Chicago, Security Pacific and First Interstate.
Some analysts thought the announcement could be a signal that the central bank also intends to cut its target for the key federal funds rate -- the interest rate banks charge one another on overnight loans of reserves -- which was cut last month from 8 percent to 7.5 percent. But Fed sources said that was not the case.
Furthermore, while the reduction in reserve requirements is being phased in over the coming month, the sources said it would be unlikely, for technical reasons if no other, for the Fed also to seek to reduce its target for the federal funds rate.
Specifically, yesterday's action eliminated a 3 percent reserve required on funds borrowed by a U.S. bank from a foreign branch, or taken in from a business or nonprofit institution in exchange for a certificate of deposit with a maturity of less than 18 months.
The level of required reserves on checking accounts, 3 percent on the first $40.5 million held by an institution and 12 percent over that figure, was not changed by the Fed.