DOES REDUCING CASH RESERVES INCREASE EFFICIENCY?

DOES REDUCING CASH RESERVES INCREASE EFFICIENCY? Paul Davies had an article in this Friday’s Financial Times which questions recent changes in bank reserve practices. He uses the framework described in today’s other post which treats reductions in bank holdings of traditional reserve assets as resulting from an attempt to increase efficiency by reducing the opportunity costs of holding lower-yield assets. He quotes a Bank of England report from earlier this week which describes the extent to which “banks sought to reduce the opportunity cost of holding liquid assets by substituting traditional liquid assets such as highly-rated government bonds with highly rated structured credit products.” One chart in the report shows that for UK banks, the proportion of total assets in traditional instruments declined from 30% in the late 60′s to almost zero in this decade. Interestingly, most of the decline took place some time ago; the proportion was under 5% through the 80′s and 90′s. Davies concludes that this kind of efficiency “can be a false economy.”