The case against the RRR

"The central bank has other powerful weapons in its armory."

A central bank is a very powerful institution, and this country’s central bank, the Bangko Sentral ng Pilipinas (BSP) is no exception. BSP is unquestionably one of the most powerful civilian institutions in the land.

BSP’s mandate under the New Central Bank Act of 1995 is the maintenance of price stability—”to maintain monetary and financial conditions conducive to price stability,” to put it more elegantly—and, to enable it to fulfill its mandate, the Act, like its 1948 predecessor, gave BSP a number of tools capable of regulating the source of stability or instability of prices—the money supply. When used, these tools have the effect of either increasing or decreasing the ability of people to produce or consume goods and services. Because of its effect on production, employment and income, these tools must be used in an adept and timely manner.

Two weeks ago, on May 17, one of the BSP’s—more precisely, the Monetary Board’s—operating tools was in the headlines. The Monetary Board decided, on the preceding day, to reduce from 18 percent the RRR (reserve requirement ratio) of universal and commercial banks. The 200-basis-points reduction will be effected in three stages: the first cut, of 100 basis points, to be effective on May 31 and two 50-basis-points cuts to go into effect on June 28 and July 26. RRR cuts for the other  types of banks will apparently be discussed at the Board’s next meeting.

It should not be very difficult for a layman to grasp the logic underlying the RRR. The concept of requiring banks to place with BSP and therefore render unavailable for lending or investing—a percentage of their total deposits—provides the monetary authority with a basis for increasing or decreasing the money supply. If it determines that the economy is slowing down, the Monetary Board reduces the RRR percentage and thereby gives the banks access to a larger part of their deposit base for lending and investing; the process is reversed, and the Monetary Board raises the RRR percentage, when the economy is perceived to be poised to operate at a level conducive to inflation. The desire to bring this country’s RRR closer to the other ASEAN countries’ RRR—at 18 percent it was the highest—and the recently announced slowing of GDP growth during the first quarter made the Monetary Board decide that a reduction of the RRR percentage was in order.

An RRR change is by no means inconsequential policy shift. At the end of 2018 the Philippine banking system had deposits totaling P11. 576 trillion. Thus, a 1 percent RRR change means a P115. 7 increase or decrease in the money supply. Universal and commercial banks now have an additional P231 billion to lend and invest in the wake of the 2 percent reduction in the RRR.

The fact that the funds being released to the universal and commercial banks through the 2 percent RRR reduction is the banks’ own funds—funds that have been deposited with them by the public and that they are not allowed to use—has made RRR the most unpopular, and the most theoretically questionable, weapon in the BSP’s regulatory armory. RRR is the only weapon that is involuntary in nature. All the other weapons —loans, rediscounts, open—market operations and swaps of acceptable financial assets of various kinds—involve no compulsion on the part of the banks. Sterilization of funds that the banks have labored hard to gather—the competition for deposits is one of the fiercest in the world of finance—and that they could profitably employ in their operations is a concept that is difficult to comprehend, let alone defend. If there has to be an RRR, let it be moderate—preferably low, single- digit—in magnitude.

At the outset it was stated that the BSP is a very powerful institution where the management of this country’s financial system is concerned. It can play—and at times has played—God with the banks. Where the state of the economy demands it, the Monetary Board can order the banks to make with the BSP, in quick order special deposits a magnitude that it considers necessary to deal with a negative economic trend. Thus, strictly speaking, there is no need for an RRR.

Against the RRR it can also be argued that doing away with the RRR would be conducive to the profitability and strength of the Philippine banking system. Being able to use their own funds—and thereby being able to operate with less borrowing—will allow the banks to operate more profitably and gradually strengthen their capital base. BSP’s regulatory function will then become easier to perform.

The difference between RRR and the other regulatory tools of the Monetary Board is indeed akin to the difference between a sledgehammer and a scalpel. RRR is the sledgehammer.

A central bank can do a good job of managing a financial system with a low—magnitude RRR, or even without an RRR at all. It has other powerful weapons in its armory.

That, briefly presented, is the case against the reserve requirement ratio.