The Fed supplies free legal reserves to the member commercial banks. On the basis of 1 dollar of free reserves, the commercial banking system acquires 208 dollars of earning assets, yet the bankers complain they are not earning any interest on their interbank demand deposits held at the Fed.

The countries cited by governor kohn as operating on a prudential reserve basis and controlled via the Taylor rule as applied to manipulation of interest rates, all report M3, the M3 that was discontinued.

They actually earn interest on the Fed deposits, too. Those are sent as dividends to the member banks. Negligible, really, given that those deposits amount to only around $40bln, out of the trillions in the banking system.

Commercial banks create new demand deposits when they make loans to, or buy securities from, the non-bank public, including the U.S. Treasury. Obviously the volume of money created is not self-regulatory. Our money has to be managed. The sine qua non of monetary management is total current control by a central monetary authority over the volume of total free legal reserves held by all money creating institutions, and over the reserve ratios applicable to their deposits.

While the individual banker is entitled to entertain the illusion that his bank is an intermediary between saver & borrower; he cannot expand loans or buy securities without adequate clearing balances, and adequate clearing balances result from a net flow of funds into his bank. But economists are supposed to understand the economies of the system, including the financial system. This includes the concept that any expansion of commercial bank credit adds initially an equal volume of demand deposits to the money supply

In the original Federal Reserve Act in 1913, the free legal reserves of the member banks were defined as Inter-bank Demand Deposits (IBDD) held in the Federal Reserve Banks (the legal reserves of the European Common Bank (ECB) are exclusively IBDDs). There were many flaws in the original Act, one being the establishment of 12 rather than one central bank. The fatal flaw was not making membership in the System compulsory for all money creating institutions.

One uses the term “fatal” advisedly. In the first 20 years of the System over 20,000 banks failed, and had not Franklin Roosevelt declared a “banking holiday” in March 1933, the lack of confidence in the banking system would have resulted in the failure of virtually every bank in the United States.

As a consequence of the more lax restrictions on the non-member, state-chartered institutions, there was continuous pressure on Congress and the Reserve authorities to engage in a “competition in laxity”. This took many undesirable forms including (1959) allowing member banks to count vault cash as a part of their free legal reserves, thus confusing liquidity and free legal reserves and making the Fed’s job of monitoring the volume of free legal reserves more difficult.

Another weakness in the Act, corrected by the Banking Act of 1933, was the lack of control over the aggregate volume of Reserve Bank Credit. When the Federal Reserve Banks expand credit, for example, by buying U.S. obligations, the balance sheets of the banks reflect an increasing in earning assets, and an equal increase in IBDD liabilities, i.e., free legal reserves.

With the Federal open market committee (FOMC) the policy-making arm of the Fed, and the Manager of the Open Market Account executing these policies through the Federal Reserve Bank of New York for all 12 Banks, we have the basic structure in place which could enable the Fed to constantly monitor and control the free legal reserves of the banking system. By controlling the volume of free legal reserves and the reserve ratios of banks (the maximum allowable ratio of bank deposits to the volume of free legal reserves held), the Fed could control the level and rate of growth of commercial bank credit with the proviso that the free legal reserves of all money creating institutions consisted exclusively of balances held in the Federal Reserve Banks.

Unfortunately, the Central bank’s enforcement and regulation of IBDDs in the Reserve Banks continued to deteriorate. With the passage of the DICMCA, the non-member banks (were allowed to have “pass-through” accounts – their IBDD account with member banks count as free legal reserves. Note: the free legal reserves non-member banks hold in member banks provide no constraint on non-member bank money creating activities. The amount of deposits these respondent banks keep in their member correspondents for check clearing and other services is much greater than the amount needed to meet their required reserves.

Ongoing institutional changes converted time deposits into auxiliary money, highly liquid assets that could, and were, converted into demand deposits on demand. The virtual elimination of reserve requirements and interest rate ceilings on all time and savings deposits will ultimately, cause the creation of new money to be unrestricted and uncontrollable. The “thrifts” will discover, as evidenced by the “savings glut/E-dollar borrowings”, that they can simply create a new balance when making a loan.

And the S&Ls, Mutual Savings Banks and Credit Unions were allowed pass-through accounts. And vault cash counts as reserves for all these institutions including the member banks. This all adds up to a free legal reserve apparatus that the Fed cannot monitor, much less control, even on a month-to-month basis (as-of adjustments are posted up to 45 days). The consequence is a delayed, remote and approximate control over the lending and money-creating capacity of the banking system. In due time yesteryears financial intermediaries will be destroyed, and a money creating system will be fostered which the Fed will be unable to control.

An intelligent monetarist policy cannot be put into effect unless the Fed’s technical staff is committed to such a policy. Beginning October 1, 2011 when the Financial Services Regulatory Relief Act of 2006 goes into effect, it will no longer be possible for the Fed to control the money supply through legal reserve management – the only method available in a free capitalistic society.

The FSRRA:

(1) “gave the Board of Governors authority to lower reserve requirements on all transaction deposits (applied to deposits above a certain threshold level) to as low as zero percent, from their previous minimum top marginal requirement ratio of eight percent.”

(2) “the extension of the privilege to member banks, the “pass through” provision, granted to non-member banks by the DIDMCA of March 31st 1980. It would allow member banks to count as reserves - their deposits in affiliated or correspondent banks that are in turn "passed through" by those banks to Federal Reserve Banks as required reserve balances” All “pass through” accounts in other banks, vault cash, etc. should be excluded. Legal reserves should never be confused with liquidity reserves. Since the reserve figures for the respondent banks do not include “required clearing balances” their correspondent balances are suspect.

(3) The act will also allow the Federal Reserve to pay interest on (a) contractual clearing balances and (b) excess reserve balances, two types of balances that depository institutions hold voluntarily at Reserve Banks, (i.e., prudential or liquidity reserves).

(4) Authorized payment of interest on reserve balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates; (i.e., the banks get paid twice. They (1) acquire “free” reserves & (2) are paid interest on the basis of their costless reserves).

(5) "the legislation increases the number of allowable transfers from interest bearing or dividend earning commercial deposits or accounts to 24 per month, from the current limit of six, enabling depository institutions to sweep funds between non-interest bearing commercial checking accounts and interest bearing accounts on a daily basis with the exception of the Industrial Loan Companies (ILCs)",( i.e., legally increasing bank lending capacity).

1 The Garn-St.Germain Act created the money market deposit account and prohibits the Federal Reserve Board from classifying the account as a transaction account for reserve-requirement purposes. 2 As of this writing, there are no restrictions on the number of transfers from the transaction deposit to the MMDA and a limit of six transfers per month from the MMDA to the transaction account (more than six transfers causes the MMDA to be subject to the same statutory reserve requirements as transaction deposits).

Note: Free legal reserves, as contrasted to liquidity reserves, are a necessary requirement of all money creating institutions, with the exception of central banks. Barring the necessary legal restraints, these institutions will create an excessive volume of money. Barring direct authoritarian controls, the only method by which the volume of money can be properly regulated is through central bank control of commercial bank free legal reserves and reserve ratios (the minimal ratios of legal reserve assets held by the commercial banks to their deposit liabilities)

To be effective, the free legal reserves of commercial banks must be confined to a bank asset that can be constantly monitored and controlled by the monetary authorities. Only Federal Reserve Bank inter-bank demand deposits (FRBIBDD) meet this condition. The volume of FRBIBDDs is almost exclusively related to the volume of Reserve Bank credit. That is Reserve Banks acquire Treasury Bills, etc., by creating IBDDs – the free legal reserves of money creating institutions.

The DICMCA:

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by means of a check or similar type of negotiable credit instrument, and whose deposits are regarded by the public as money, can create new money provided that the institution is not encountering a negative cash flow. The DIDMCA of March 31st 1980 allowed the (thrifts) S&Ls, MSBs, & CUs the option to classify any or all of their deposits as checking accounts. This results in legalizing the universal use of drafts to transfer the ownership of share and savings accounts. And these drafts can be cleared through the commercial bank clearing system.

Over the last 27 years these depository institutions have used their newly acquired legal status to take advantage of their broadened lending opportunities; e.g., the fallout of this legislation was an imported “savings glut” [sic]; which wasn’t sterilized by the “trading desk”; because of bank reserve avoidance on E-dollars (through the selective classification of deposits/and reserve ratio differentials); which produced artificially low interest rates; and contributed to an excessive expansion of new money & bank credit; and because of the lag in the recognition in the rate-of-change in monetary flows (MVt); an economic bubble of unprecedented proportions.

New Zealand.is the definitive example of this problem. The Reserve Bank of New Zealand pioneered zero reserve requirements and is now confronted with suffocating interest rates and inflation.

Originally, all of these depository institutions were financial intermediaries, intermediary between saver and borrower. But over time these institutions have evolved into money and credit creating institutions (depository institutions were commingled). The progression of bank credit creation by the depository institutions is a “system” process. No depository institution or minority group (from an asset standpoint) can expand credit (and the money supply) significantly faster than the majority group are expanding. I.e., if the member banks hold a substantial majority of total bank assets the fed, through controlling the reserves of the member banks can control the expansion of total bank credit, member & non-member. Consequent to the Act, as time passes, it is possible to know less and less about money. The net effect in time will be to make the Fed’s job of controlling the volume and flow of money impossible.

Under these circumstances, the Fed hasn’t been able to “run a tight ship”. It is a valid assumption that the non-member banks and other depository institutions have taken advantage of their increased free legal reserves and clearing balances by expanding credit and creating new money. The portion that represents the supply of money & the portion that represents savings/investment accounts is unknown & unknowable.

What the net expansion of money will be, as a consequence of a given injection of additional free legal reserves, nobody knows until long after the fact. And the whole process has been initiated by the banks, not the monetary authorities – despite the Manager of the Open Market Account attempts to manipulate the economy with the FFR using a “creeping peg”. Under the current practices, there’s no end to “stop-and-go” monetary management. We are left with two ways (other than amending the law) to bring money creation under control, (1) a financial collapse such as in 1932-33, or (2) a government controlled system of money creation – and credit allocation.

The implementation of the Term Auction Facility has vastly accelerated the enactment and exercise of the Financial Services Regulatory Relief Act of 2006 provisions.

As a system (on the H4.1), Term auction credit has replaced non-borrowed reserves (interbank demand deposits at the Reserve Banks) plus vault cash (with minor exceptions).

Most banks no longer face binding statutory reserve requirements -- increasing amounts of vault cash (including ATM networks) plus retail deposit sweep programs have wiped aside such binding requirements.

A further advantage of the auction facility is the liberal rules regarding the types of assets that the discount window folks will accept as collateral -- including (gulp) certain CDOs.

Such securities are not purchased by the Open Market Desk as it supplies nonborrowed reserves.

The difference in the type of securities that the Fed will accept at the Window and at the Desk perhaps is the answer.

The commercial banking system is close to operating on a prudential or liquidity reserve basis (years before the Acts anticipated launch in Oct 2011). That is, only vault cash & borrowed reserves are utilized.

Using what economists call the "Lombard Facility" (just another name for the federal funds bracket racket or lending & deposit rates), the Central Bank provides advances at a penalty rate (the expected rate level above overnight market interest rates).

If the Federal Reserve had the authority to pay interest on excess reserve balances and contractual clearing balances (two types of balances that depository institutions hold voluntarily at Reserve Banks), and did so, that interest rate would act as a minimum for overnight interest rates, then we would be at that stage.

With the FSRRA of 2011 the commercial banks will get paid twice. (1) the CBs will get new free-gratis legal/prudential reserves on the basis of which these CBs can expand their earning assets. (2) then the Fed will pay them interest on their IBDDs or now it will be IBTDs (inter-bank time deposits), and the Treasury will be left out.