From January of next year, the Central Bank will double the funds that banks must have on deposit with it, free of charge and without interest. These are reserves that banks have to keep with the central bank to have funds in case some people suddenly start withdrawing deposits. And since last year they have no interest on this money.
Historically, these reserves arose out of the need for banks to keep part of their assets in a highly liquid form, and today they are mostly not given much attention. The CNB justified this move by “reducing the costs of monetary policy while maintaining its effectiveness”. Of course, only she knows why she actually does that, or rather the relevant specialist departments and the bank board.
However, with this step, it definitely contradicts both the practice of its behavior over the past 25 years, the knowledge of modern monetary theory, and the way it describes mandatory minimum reserves and their use for monetary policy on its own pages.
As for the effects of this step, the volume of mandatory minimum reserves will increase by roughly 130 billion by doubling them from two to four percent. It can be assumed, or rather the CNB probably assumes, that their increase can immediately reduce by the same amount the funds that must be withdrawn for monetary policy market rate.
By increasing reserves in the event of an expected drop in their rates below 4%, the CNB will save about CZK 7 billion per year, which it currently pays commercial banks for withdrawing money. With all due respect to the billions, given the scope of the CNB’s activities, it is not much to fix.
Just for comparison, I present some data from the CNB’s financial statements for last year: profit of CZK 55 billion, interest income of CZK 66 billion, interest expenses of CZK 196 billion, balance sheet size of CZK 3,384 billion.
Units of billions are important in the operation of the CNB, for the reputation of the central bank proper management must be taken care of, and it is good that the CNB has increased its efforts in this regard in the last year. From the point of view of their monetary policy activities, however, units of billions are rather “icing on the cake”.
The 7 billion crowns in savings is also an upper limit. This is the estimated cost to the CNB of the two percent by which it increased the mandatory deposit, which it would otherwise have to pay interest to the banks.
From the point of view of commercial banks, increasing mandatory minimum reserves penalizes client deposits, thus reducing banks’ interest in holding deposits and, of course, their willingness to earn interest on them.
The increase in mandatory minimum reserves follows last year’s abolition of interest on mandatory reserves – the CNB justified this move by harmonizing with the conditions of the European Central Bank. It can be said that as a result of the changes in the area of mandatory minimum reserves, there will be a decrease in interest on deposits at banks by “slightly” above 0.1%.
In addition, the more than sufficiently liquid banking system in the Czech Republic allows banks to optimize, i.e. reduce, the amount of deposits that banks hold.
From the point of view of the prudence and security of our financial system, this will not be a step in the right direction, but the CNB has created incentives through its changes in the area of mandatory minimum reserves.
Which brings us to mandatory minimum reserves (hereafter PMR) in the context of central banking. Here we quote from the website of the CNB, which defines their three basic functions (using the work of the IMF as a basis for this): prudential, monetary policy and liquidity.
Since monetary policy was explicitly mentioned in the press release, I will return to it in the next paragraph.
Regarding the first function of the other two, i.e. the prudential one, the CNB describes today’s theory as follows on its website: activity on specific markets… however, with the existence of the mentioned more sophisticated instruments… he considers the prudential role of the PMR to be rather obsolete.” (emphasized here and further by the author).
This does not sound like a blockbuster, but it should be noted that it is precisely from this function that the requirement for the existence of mandatory minimum reserves arose.
For the last liquidity function, the CNB website and the literature cited by it find some understanding: “Mandatory minimum reserves thus… facilitate the management of liquidity of commercial banks, enable a smoother flow of payments and encourage trading on the interbank market, and at the same time can help the transmission of monetary policy to be smoother. Of all the mentioned functions of PMR, the professional literature usually considers this argument as practically the only relevant reason justifying the existence of PMR in developed countries even in modern times”. So now we know why the CNB did not cancel the reserve requirement to 2% of the base, simply deposits, even after 1999. But why he considers it necessary to double them today, we certainly won’t read here.
Which brings us to the relationship between mandatory minimum reserves and monetary policy. Here again, the CNB website is quite clear and states that “the function of the PMR as a monetary policy instrument is considered in the traditional literature in connection with the use of an older theoretical model of money creation… However, none of these assumptions correspond to the modern implementation of monetary policy in developed countries.” In a situation where the central bank in the inflation targeting regime determines the monetary policy interest rate… PMRs play practically no role from this purely regime monetary policy point of view”.
However, the CNB also states that mandatory currency reserves can play a role and “supplement the instrument of nominal interest rates”, to state that “The use of PMR for the purpose of managing capital inflows and overall influencing monetary policy conditions is in practice applied as a standard in some developing countries, typically in Latin America.”
We will add that it is also used in the practice of central banks insufficiently equipped with currency reserves and with a relatively exotic relationship to the financial and fiscal stability of well-known European economies, such as Turkey or Hungary, which is less distant from us.
However, the text continues, “The disadvantage of using PMR for this purpose is, on the one hand, that it is a relatively crude and imprecise tool… and, on the other hand, the fact that it leads to market distortions. Non-interest-bearing reserves represent a hidden tax for the banking sector and one can expect at least a partial transfer of the tax burden to bank clients, i.e. to companies and households… This fact can have two consequences: it can lead to a partial transfer of activity and risks to non-banking, unregulated institutions (so-called shadow banking) with a competitive advantage over banks, and small and medium-sized companies that are more dependent on bank financial intermediation may also be disadvantaged.”
Which brings us back to the CNB’s motivation to double the required minimum reserves. Let’s speculate.
It is evident that a stable and liquidity-rich financial system excludes the prudential or liquid motive, after all, they are not even mentioned in the press release of the CNB. The wording about “maintaining the effectiveness of monetary policy” does not indicate any need to play with some new monetary instrument, after all, if the monetary authority needs to influence a weakening exchange rate due to the crisis in the Near and Middle East, it can always resort to verbal interventions and the amount of our reserves will guarantee , that they will be taken more than seriously.
So is it really about cost reduction? Here, however, not only shareholders of commercial banks should pay close attention. It is possible that the CNB really doesn’t mind that the latest steps it implemented in the area of PMR move our monetary policy towards Lower Hungary, Asia Minor and Latin America.
If the CNB is really trying to improve its bottom line, it doesn’t have to stop at doubling PMR.
By law, when determining the amount of PMR, it is limited to 30% of the base. The current volume of mandatory minimum reserves, defined as of the New Year at 4% of the base, can theoretically increase another 7.5 times. And even in practice, the scope for reducing monetary policy costs is by no means exhausted.
It follows from the CNB’s annual report on the economic results for the year 2023 that last year the CNB sterilized, i.e. drained from the market for interest, an average of CZK 2,547 billion with costs at the level of CZK 181 billion.
The current increase of PMR by 2%, after which, according to my estimation, their volume will be approximately CZK 260 billion and with which the CNB will improve its economic result next year to CZK 7 billion, can therefore be repeated many times in order to straighten out the economy.
At the same time, the CNB’s step from this week testifies to the fact that the findings of the current monetary theory, as formulated by the CNB itself, were not a factor that would burden its governing body, i.e. the Bank Board.
Of course, there is no need to dramatize the situation, the improvement of the management of the CNB by the amount of approximately CZK 7 billion, its transfer to the management of the banks and then from them to the Czech economy is not a serious shock given its size today.
However, I am convinced that it would be more than appropriate for us to find out how the current bank board thinks about prioritizing the economic result at the expense of the quality of monetary policy in the long term, as it defines it.
And not only so that we don’t get surprised soon. I am convinced that it could be a useful and productive reflection for its members as well.