Thomas Palley

The establishment of the euro represents an important step in the creation of an integrated European economy. Over time it should yield dividends as increased competition and lower transaction costs generate increased efficiency. However, member countries have had to give up their own exchange rates and interest rates, which has created problems for economic management by reducing the number of policy instruments. In particular, the European Central Bank (ECB) must wrestle with how to set interest rates when some countries are booming, while others suffer high unemployment. Asset based reserve requirements (ABRR) can fill this policy instrument gap.

ABRR require financial firms to hold reserves against different classes of assets, with the regulatory authority setting reserve requirements on the basis of its concerns with each asset class. One concern may be that an asset class is too risky; another may be that an asset class is expanding too fast and producing inflated asset prices.

By forcing financial firms to hold reserves, the system requires that they retain some of their funds as non-interest-bearing deposits with the central bank. The implicit cost of forgone interest must be charged against investing in a particular asset category, reducing the return from that asset type. As a result, financial firms will reduce holdings of assets with higher reserve requirements, and shift funds into other asset categories that are relatively more profitable.

Optimum effectiveness of this approach necessitates system-wide application. If applied only to banks, ABRR would simply encourage the shifting of lending outside the banking sector and could erode the effectiveness of monetary control. To succeed, reserve requirements must be set by asset type, not by who holds the asset.

A nationally applied system of ABRR that covers all financial firms can powerfully reinforce central banks’ existing control over short-term interest rates and increase the efficacy of monetary policy. By adjusting reserve requirements on all financial sector assets – rather than a narrow pool of banking industry deposits, as is now the case – a central bank can engineer monetary policy moves that forcefully affect the total supply of credit and influence underlying patterns of real economic activity.

For the euro zone, ABRR are additionally attractive because they can help address the instrument gap problem. This is because the ABRR can be implemented on a geographic basis by varying reserve requirements across countries. Property lending, which has been a major concern, is particularly suited to this. Thus, if Spain and Ireland are suffering excessive house price inflation, the ECB could raise reserve requirements on mortgage loans secured by property in those countries. That would quickly raise mortgage loan rates in Spain and Ireland without raising rates in other countries.

Geographically contingent ABRR will create incentives to shop for credit across countries. That means ABRR that have a geographic dimension will work best when linked to geographically specific assets that cannot escape. This includes mortgage lending that is secured by collateralized property, and shares for which legal title is registered where companies are incorporated. But jurisdictional shopping is expensive, and that itself is a cost that can allow ABRR to create cross-country interest rate differentials for wide categories of assets. Finally, jurisdictional shopping would tend to promote cross-country financial integration, which is a long-term goal of the euro project. So even here there is an upside.

In addition to these benefits, ABRR also act as automatic stabilizers. When asset values rise or when the financial sector creates new assets, ABRR generate automatic monetary restraint by requiring the financial sector to come up with additional reserves. Conversely, when asset values fall or financial assets are extinguished, ABRR generate automatic monetary easing by releasing reserves previously held against assets. In all of this, ABRR remain fully consistent with the existing system of monetary control as exercised through central bank provision of liquidity at a given interest rate.

In addition these macroeconomic policy benefits, ABRR enable central banks to surgically target sector imbalances without recourse to the blunderbuss of interest rates that inflict damage on all sectors regardless of their condition. For example, if a monetary authority was concerned about a stock market bubble generating excessive consumption and risk exposure, it could impose reserve requirements on equity holdings. This would force financial firms to hold some cash to back their equity holdings, which would lower the return on equities and discourage such investments.

At the microeconomic level, ABRR can be used to allocate funds to public purposes such as inner city revitalization or environmental protection. By setting low (or no) reserve requirements on such investments, monetary authorities could channel funds into priority areas, which would have a similar effect to government subsidized credit and guarantee programs that have often been used as part of regional policy. This is another feature that should be appealing to all policymakers, and especially those in Euroland.

N.B. The full detailed workings of a system of ABRR are described in “Stabilizing Finance: The Case for Asset-Based Reserve Requirements,” a report put out by The Financial markets Center that is posted at www.fmcenter.org.

This entry was posted on Friday, February 3rd, 2006 at 10:48 am and is filed under Europe. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.