A STUDY OF THE IMPACT OF RESERVE REQUIREMENTS ON THE COMPOSITION OF A BANK'S ASSET PORTFOLIO

The financial industry in the United States is one of the most important sectors of the economy. As such it has also become one of the most heavily regulated industries in the economy. The goal of the regulation, in the most general sense, is to force the financial industry to conform to patterns of behavior which are considered desirable. A question which logically follows is, to what extent is government regulation of the financial industry successful? The goal of this thesis is to investigate the impact of one form of regulation on one sector of the financial industry. Specifically, the thesis is concerned with the impact of changes in the reserve requirement on the composition of the bank's portfolio of earning assets.;Three of the above four hypotheses were tested in the thesis using ordinary regression analysis. The first two hypotheses which were tested, (a) and (b) above, found partial support in the empirical results. The third hypothesis tested, (d) above, yielded mixed results.;The model which is developed in the thesis depicts the bank as a firm which attempts to maximize the rate of return on bank capital. The production function of the bank consists of two parts. The first portion involves the transformation of deposit liabilities (inputs) into loanable funds. The second part of the production function involves the distribution of loanable funds among the competing asset types (outputs). The relationship between inputs and outputs is the traditional one of equality between marginal cost (the cost of an additional dollar of loanable funds) and marginal revenue (the revenue derived from the purchase of an additional dollar's worth of assets). The testable implications which are derived from the model are: (a) reserve requirements for banks which are not members of the Federal Reserve System are generally ineffective, (b) reserve requirements for banks which are members of the Federal Reserve System are effective and as a result cause member banks to earn a lower rate of return on total assets than comparably sized nonmember banks, (c) assuming a perfectly elastic supply of government securities it can be shown that changes in the composition of the asset portfolio will not affect the size or composition of liabilities, while at the same time changes in the cost of deposit liabilities will affect only the quantity of government securities held, and (d) changes in reserve requirements will affect the composition of member bank portfolios by altering only the quantity of reserves and government securities that are held.