Elimination of the reserve requirement: impact on liquidity at community banks versus non-community banks

Abstract

PurposeThe purpose of this paper is to better understand the differences between community and non-community banks (CBs and Non-CBs) in the US. As the former have been declining in numbers, previous literature shows inherent differences between the business models of CBs and Non-CBs. This study attempts to gauge whether the impact of the reserve elimination during the Covid pandemic affected all banks similarly or whether community banks showed a differentiated response.Design/methodology/approachOn March 26, 2020, the Federal Reserve, at the onset of the Covid pandemic, altered the depository institution reserve requirement for the first time since 1992. This significant change in policy led to the reserve requirement reduction from 10% to 0%. This study examines the impact of the 2020 reserve elimination on all community banks and non-community banks in the US and finds that although the level of cash to assets increased at both types of depository institutions post reserve elimination, the impact on liquidity-focused ratios was more pervasive at community banks in the first quarter post the regulatory shift. Among community banks, the largest depository institutions experienced the biggest balance sheet adjustments in the June 2020 quarter that followed the change in Federal Reserve’s policy. Further, the study finds that over two-quarters post reserve elimination, the non-community banks demonstrate a greater increase in balance sheet liquidity. Past literature shows that community banks tend to carry more liquidity than non-community banks and small community banks tend to carry more liquidity than their larger counterparts. These previous findings may provide some explanation for the different speed documented in this study at which various banks have reacted to the reserve elimination in 2020.FindingsThis research finds that community banks had a quicker response to the change in the reserve elimination, showing quick increases across liquidity ratios. The larger non-community banks tended to play catch up, increasing their liquidity in the subsequent quarter. The study also shows that the changes in liquidity were initially driven by the segment of large community banks.Originality/valueThis study looks at how the reserve elimination enacted by the Federal Reserve in March 2020 in response to the Covid pandemic affected community versus non-community banks. Currently, as far as the authors know, there are no other published papers that look at this issue.