Listen to the article
A debate is currently unfolding in Lebanon over the concept of mandatory reserves. The questions at the forefront: Can the Central bank of Lebanon dispose of them freely? Should they be returned to the banks? Are they distinct from other loans that the Central bank has received from banks? Should this system be maintained? Before addressing these questions stemming from the unprecedented Lebanese crisis, it is prudent to delve into the underlying rationale for mandatory reserves. This exploration has led us to broader insights that extend beyond the Lebanese context.
As for the anticipated answers, some are self-evident, while others require deeper reflection and a renewed monetary consensus. Mandatory reserves are one of the tools within the monetary policy. They play a vital role in regulating the operational scope of banks by placing constraints on their lending capacities. For instance, if the reserve requirement is set at 10% on deposits, banks cannot lend more than 90% of the deposited amounts. Thus, economic growth can be curtailed by increasing the reserve requirement and stimulated by decreasing it. Mandatory reserves also contribute to stabilizing the banking sector during times of substantial deposit withdrawals. In practical terms, if a bank faces a demand for a $100 million withdrawal while maintaining a 10% reserve requirement, it already holds 10% of the sought-after amount.
Nevertheless, it is important to acknowledge that this simplified explanation merely skims the surface of a multifaceted issue. Monetary authorities possess the discretion to establish reserve requirements for deposits across various currencies or specific ones. They can apply these requirements to loans, or selectively to certain loan categories. They can also establish reserve requirements based on certain deposit sizes. Additionally, monetary authorities may classify both liquid assets within banks and funds deposited with external financial institutions as integral components of the overarching reserve structure.
Nevertheless, the current discourse seems to be confined to discussions about the ownership, existence, and preservation of these infamous reserves. It fails to delve deeper into their underlying rationale and distinctive characteristics. Mandatory reserves represent only one facet of the toolkit available to monetary authorities. In developed nations, their relevance is waning to the point where their rates are nearing zero in regions such as the Eurozone, the United States, Canada, the United Kingdom, and Australia. These countries possess more sophisticated mechanisms to influence interest rates and liquidity.
Further automatic stabilizers have been implemented, encompassing liquidity and solvency ratios within the banking sector—ratios that often do not extend to non-banking financial entities. Moreover, as ultimate sources of emergency funding in these countries, typically central banks, have the capacity to manage specific or systemic crises regardless of the mandatory reserves’ level. In less developed countries, mandatory reserves tend to be directed towards strengthening central bank resources, enabling them to navigate currency fluctuations, depositor rushes to banks (“bank-runs”), and even contribute to government funding. Consequently, these reserves have persisted at rates uncommon elsewhere. In Lebanon, the current rate stands at 14%, while in West Africa, it rests at 5%.
In essence, this instrument is regarded in advanced nations as an outdated artifact, while elsewhere, it serves broader purposes beyond monetary policy, ultimately straying from its original mission. Should mandatory reserves, therefore, be discredited and relegated to the annals of obsolete practices?
Contrary to common assumptions, mandatory reserves offer far greater flexibility and precision than the instruments commonly employed today. For instance, in the Eurozone, monetary policy led, in the early days of the euro, to excessive inflation in the southern European countries followed by a severe recession in the same nations from 2009 onwards. This predicament was due to the European Central Bank’s monetary policy being built upon the assumption of a single solution fitting all (“one size fits all”). However, if the European Union had instead adopted the “Open Market” instrument for the entire region—where the central bank intervenes in the money market to inject or withdraw liquidity from financial institutions, thereby influencing the market interest rate—coupled with an additional mechanism (mandatory reserves) tailored to countries facing differing economic conditions compared to the major EU members, Europe could have potentially sidestepped a major crisis.
Likewise, the United States could empower regional Federal Reserves (central banks) to adjust their local mandatory reserve rates based on the economic situation within their respective regions.
Looking at developing countries, which inherently should experience higher growth rates, the guiding principle should revolve around stabilizing economic activity through mandatory reserves. When economic momentum accelerates, these reserves could be bolstered to curtail excessive bank lending, and conversely scaled back during downturns. This approach stems from the fact that developing nations have limited monetary autonomy and lack access to the extensive toolkit of major central banks. Hence, their central banks could concentrate on implementing adaptable and context-specific mandatory reserve strategies.
Reflecting on the insights provided in this concise exposition and proposal on a rather highly technical subject, one can assert that the utilization of mandatory reserves in Lebanon as currently practiced is at odds with their intended purpose and counterproductive. Maintaining a 14% reserve rate, as if the economy is overheating, is untenable. Returning at least three-quarters of the remaining reserves immediately to the banks—significantly more than what the IMF is contemplating to lend to Lebanon and a substantial infusion of liquidity relative to the current GDP—would initiate a restoration of trust, stimulate the economy, and enable the banking sector to fulfill its core function of extending credit. The remaining quarter would provide the Banque du Liban (BDL) the necessary leeway and flexibility to introduce innovative strategies for managing mandatory reserves. Additionally, economists beyond Lebanon might find it worthy to reconsider this undervalued instrument. They could potentially unveil notable benefits and gain insights from Lebanon’s approach in proficiently harnessing mandatory reserves.
(*) Riad Obégi is the CEO of BEMO Bank.
