Revisiting legal reserve requirements of banks

According to official statistics, commercial banks place around JD2.5 billion of remunerated deposits at the Central Bank of Jordan (CBJ).

The weighted average interest rate paid by the CBJ on these funds stands currently at around 3 per cent, which is equivalent to about JD75 million per annum. 

After taking into account the 35 per cent income tax rate on commercial banks, the net annual fiscal cost of these deposits would approximately reach JD50 million.

From a pure fiscal perspective, it seems that the government subsidises commercial banks’ income with a substantial amount of tax payers’ money, which could otherwise be allocated to bridge the government deficit and suppress mounting pressures on household finances.

Nonetheless, offering commercial banks remunerated deposit facilities at the CBJ is part of open market operations that aim at maintaining monetary stability in the country.

By having a direct control over short-term, risk-free interest rates, the Central Bank ensures an effective channelling of monetary policy goals and directions.

Although this comes at a vast cost when interest rates increase and excess liquidity levels pile up, CBJ accepts to pay the bill in return for an effective monetary policy that maintains the attractiveness of the dinar, among other key monetary priorities.

However, growing fiscal pressures on the government may prompt CBJ to explore less costly open market operations that could achieve similar outcomes.

In this regard, CBJ may revisit the rate of legal reserve requirements on customer deposits at commercial banks.

Instead of paying commercial banks high interest rates on their excess liquidity, a higher legal reserve rate will oblige commercial banks to park part of this liquidity at CBJ at zero interest rate.

Higher reserve requirements have various advantages, besides reducing the fiscal costs incurred by CBJ and the government.

By withdrawing excess liquidity from the market, competition among banks over customer deposits will intensify and interest rates on deposits will go up; the same envisaged outcome of paying high interest to commercial banks on their excess liquidity.

Notwithstanding the similar outcomes — higher interest rates and higher legal reserve rates — the drawbacks of the latter proposal should be taken into great consideration.

Reducing the amount of excess liquidity in the market may lower the ability of banks to absorb swings triggered by internal and external uncertainties.

In addition, higher reserve requirements may intensify the structural concentration of liquidity at the biggest two banks in the market. 

It may also prompt banks to apply more aggressive pricing criteria for credit facilities to individuals, corporations and the government.

However, policy makers should keep in mind that reserve requirements were originally 12 per cent before going down to the outstanding rate of 7 per cent, as part of the expansionary measures adopted to encounter the global financial crisis since 2009.

Moreover, monetary authorities have a variety of effective tools to absorb potential liquidity shortages in the market other than mounting excess liquidity. Repos, FX swaps and outright bond purchases are examples of monetary tools deployed successfully to weather market liquidity pressures in 2012 and 2013.

Another factor that may encourage CBJ to utilise legal reserves in tuning the monetary policy is rooted in the newly amended Central Bank Law, which enables monetary authorities to impose different legal reserve requirements based on various criteria, including deposit segments and bank sizes.

This may assist CBJ in staving off considerable drawbacks of applying higher reserve requirements, as it will allow targeting banks with higher excess liquidity and minimise adverse repercussions on smaller players in the market.

It is anticipated that CBJ will increase interest rates once more before the end of 2017. Another choice worth considering would be to increase legal reserve requirements from 7 per cent to 9 per cent.

The writer, an economist and columnist, contributed this article to The Jordan Times.