donald l kohn : regulatory reform proposals remarks by mr donald l kohn, member of the board of governors of the us federal reserve system, before the committee on banking, housing, and urban affairs, u. s. senate, 22 june 2004. * * * chairman shelby, senator sarbanes, and members of the committee, thank you for the opportunity to testify on issues related to regulatory relief. the federal reserve strongly supports this and other efforts to review the federal banking laws periodically to determine whether they may be streamlined without jeopardizing the safety and soundness of this nation ’ s insured depository institutions or undermining consumer protection or other important policy principles that congress has established to guide the development of our financial system. earlier this spring, chairman shelby and senator crapo asked the federal reserve board to identify its top two or three legislative priorities for regulatory relief. in his letter of april 23, chairman greenspan highlighted three proposals that the board has supported for many years : authorization for the federal reserve to pay interest on balances held by depository institutions in their accounts at federal reserve banks, repeal of the prohibition against the payment of interest on demand deposits by depository institutions, and increased flexibility for the federal reserve in setting reserve requirements. as we have previously testified, unnecessary legal restrictions on the payment of interest on demand deposits at depository institutions and on balances held at reserve banks distort market prices and lead to economically wasteful efforts by depository institutions to circumvent these artificial limits. in addition, authorization of interest on all types of balances held at reserve banks would enhance the toolkit available for the continued efficient conduct of monetary policy. and the ability to pay interest on a variety of balances, together with increased authority to lower or even eliminate reserve requirements, could allow the federal reserve to reduce the regulatory and reporting burden on depository institutions of reserve requirements. let me explore each of these topics at greater length. interest on reserves and reserve requirement flexibility for the purpose of implementing monetary policy, the federal reserve is obliged by law to establish reserve requirements on certain deposits held at depository institutions. banks, thrifts, and credit unions may satisfy their reserve requirements either by holding cash in their vaults and atm machines, which they need in any case for normal business activities, or by holding balances at reserve banks. because no interest is paid on the balances held at reserve banks to meet reserve requirements, depositories have an incentive to reduce their reserve

requirements to a minimum. to do so, they engage in a variety of reserve avoidance activities, including sweep arrangements that move funds from deposits that are subject to reserve requirements to those that are not and to money market investments. these sweep programs and similar activities absorb real resources and therefore diminish the efficiency of our banking institutions. the payment of interest on required reserve balances would remove a substantial portion of the incentive for depositories to engage in such reserve avoidance measures, and the resulting improvements in efficiency should eventually be passed through to bank borrowers and depositors. although paying interest on reserves would yield significant benefits, even greater efficiencies and regulatory burden reduction might be realized by substantially reducing, or even eliminating, reserve requirements. to understand how elimination of reserve requirements could be consistent with effective monetary policy and the other legislative changes that would be necessary to realize this greater reduction in regulatory burden, i need to review with you the role of reserve requirements in the implementation of monetary policy and alternatives that might be possible. the federal reserve ’ s federal open market committee ( fomc ) conducts monetary policy by setting a target for the overnight federal funds rate - the interest rate on loans between depository institutions of balances held at reserve banks. while the federal funds rate is a market interest rate, the federal reserve can strongly influence its level by adjusting the aggregate supply of balances held at reserve banks. it does so through open market operations - the purchase or sale of securities that causes increases or decreases in such balances. however, in deciding on the appropriate level of balances to supply in order to achieve the targeted funds rate, the federal reserve ’ s open market desk must estimate the aggregate demand for such balances. at present, a depository institution may hold three types of balances in its account at a federal reserve bank - required reserve balances, contractual clearing balances, and excess reserve balances. as noted above, required reserve balances are the balances that a depository institution must hold to meet reserve requirements. a depository institution holds contractual clearing balances when it needs a higher level of balances than its required reserve balances in order to pay checks or make wire transfers out of its account at the federal reserve without incurring overnight overdrafts. currently, such clearing balances do not earn explicit interest, but they do earn implicit interest for depository institutions in the form of credits that may be used to pay for federal reserve services, such as check clearing.