AN ANALYSIS ON THE INCIDENCE OF EXCESS RESERVES:

CASE OF THE PHILIPPINES

A Thesis Presented to the

Philippine Economics Society

By

Polintan, Felipe T. Jr.

Poquiz, Jasmin S.

Simon, Justin G.

October 2013

ABSTRACT

Excess Reserves are still an important part of the central banks’ monetary instrument via reserve requirement and open market operation. Hence this paper provides an analysis on the behavior of excess reserves for policy implications and its impact to the financial system. It could also help the thrift banks to evaluate their reserve management. This study focused on the behavior of thrift banks’ excess reserves from 1990 to 2010.

Primarily, the reason why banks hold excess reserves is to provide a buffer against uncertainty. Since the timeline covers two crises that affected the Philippines, the Asian and Global Financial Crisis, one of the objectives of this paper is to know how thrift banks responded to the credit crunches. Additionally, interest rates specifically 91-day Treasury Bills rate was used as an opportunity cost of holding excess reserves. Finally, the researchers used demand deposit to further observe banks’ level of excess reserves as adapted in the model of Dow (2001).

A regression analysis was used to test the short-run effects of excess reserves against the three explanatory variables. Demand deposit and crisis are presumed to have a positive relationship, while interest rates to be negatively correlated with excess reserves. The results confirm the hypothesis of demand deposit. However, the same was not true in the case of interest rate. This paper also found different banking behaviors from the two crises.

Extensive studies about excess reserves in the Philippines are strongly suggested since there had been lack of support and evidences noticed in the case of this country. The researchers suggest that the central bank would make data on excess reserves on daily basis to be publicly available since most of the literature provides a detailed study on that. Furthermore, this could help banks to determine whether they are maximizing profitability or having enough buffers in case of shocks.

Key words: Excess Reserves, Demand Deposits, 91-Day Treasury Bills Rate, Asian Financial

Crisis, Global Financial Crisis

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TABLE OF CONTENTS

PageTitle 1Abstract 2Table of Contents 3List of Tables 4List of Figures 4

CHAPTER 1 INTRODUCTION 5Key Issues/Trends 5Objectives of the Study 8Significance of the Study 8

CHAPTER 2 REVIEW OF RELATED LITERATURE 9Synthesis 23Simulacrum 24

CHAPTER 3 RESEARCH METHODS 25Research Design 25

Data Gathering Procedure 26Data Analysis 26

CHAPTER 4 DATA PRESENTATION AND ANALYSIS 29Data Presentation 29Results and Findings 30

CHAPTER 5 CONCLUSIONS AND RECOMMENDATIONS 38Conclusions 38Recommendations 41

REFERENCES 43APPENDICES 46ABOUT THE AUTHORS 55

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LIST OF TABLES

Table 1: Regression Analysis 25

Table 2: Ramsey RESET 43

LIST OF FIGURES

Figure 1: Simulacrum 20

Figure 2: Scatterplot 42

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An Analysis on the Incidence of Excess Reserves: Case of the Philippines

Felipe T. Polintan Jr., Jasmin S. Poquiz, Justin G. Simon

Introduction

Financial crises have always been a great threat to different economies. Two of the most

recent crises faced by the Philippines were the Asian Financial Crisis and Global Financial

Crisis. According to Asian Development Bank (ADB), Asian Financial Crisis of 1997 had

significant detrimental effects on a number of neighboring countries of the Philippines and other

economies that caused a slow growth performance. Moreover, according to Aslam (2012), one of

the major factors that contributed to the Asian Financial Crisis was the inflow of Foreign

Portfolio Investment (FPI) from different countries in stocks and great amount of short term

intra-bank loans. When these portfolio investments penetrate the banking system, it gives

pressure to the domestic expenditure and increases the current account deficit. And its outflow

can decrease asset prices, interest rates, lower the value of local currency and it results in

liquidity problems in the banking sector.

Another point of view given by Corsetti et. al., (1999), was that the Asian Financial

Crisis rooted mainly from the moral hazard problem of different industries. For some

institutions, it was seemed to be rampant because government gave guarantees to private projects

like direct subsidies and supporting policies that directed credit to favor the firms and other

industries. This was because the government would like to induce higher output from firms to

have high rates of economic growth. These supports given by the government made the firms to

be more complacent thus overlooked the costs and riskiness of investment projects. The core

implication of this problem was that a pressure to profitability does not encourage institutions to

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be more cautious in lending and to follow financial strategies reducing the overall riskiness of

their portfolios.

On the other hand, the Global Financial Crisis was caused by housing bubble in United

States which peaked in 2007. It was caused by the values of securities tied to U.S. real estate

pricing to fall, damaging financial institutions worldwide (Shahrokhi, 2011). Also, Cook (2011)

strongly argued that this sub-prime crisis was actually the greatest money and credit excess in the

history of the world.

Gorton (2010) however argued that that there was banking panic on August 2007.

Depositors rushed to banks and demanded their money back. But banks were not able to suffice

these demands immediately since they have lent the money out already or they had it for long-

term bonds. To honor these demands, banks must sell assets but only the Federal Reserve had the

capability to buy the assets. It only proved that housing bubble led banks to hold illiquid assets

thus they were not able to suffice the demands of the depositors.

In addition, Aslam (2012) stated that the U.S. economic crisis was consisted by the

boom-bust-cycles in the stock market, housing market and financial market. The crisis in the

stock market spilled over not only to technology related industries but also in automobile,

electronics and other manufacturers. In the late 2007 the subprime mortgage defaults contributed

partly to the increase in unemployment in the United States. The emergence of cheap money and

low interest rates worsen the sub-prime crisis. Low interest rates attracted property sectors to

increase the demand for credit. Property loans of mortgage loans were repackaged and sold in

form of securities. The main purpose of securitization of loans was to increase bank liquidity in

order to meet the demand from the household sector.

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One of the most remarkable factors in the banking system that had been noticed and

talked about by a lot of Western researchers was the excess reserves. Notice that in the global

financial crisis, the United States significantly increased their level of excess reserves. Keister

and McAndrews, (2009) pointed out that in the U.S., their excess reserves rose from $45 billion

to $900 billion by January 2009. A lot of analysts saw the surge in excess reserves as an

alarming development in the banking system. This simply emphasized that during crisis, instead

banks lend funds out to the households, firms and other banks, and they were hoarding it and put

it in their reserves. Other observers saw the hoarding of excess reserves as a sign that the

mechanisms implemented by the Federal Reserve during the crisis have been ineffective. Instead

of restoring the flow of credits, the money that the Fed has lent to banks since September 2008 is

in the banks’ reserves. In addition, it was also been identified by Edlin and Jaffee (2009) that

excess reserves were the problem behind the continuing credit crunch.

Talasli (2010) stated that uncertainty increases the level of excess reserves. Since the

Philippines has also been affected by the two great uncertainties: Asian Financial Crisis

(Nagayasu, 2001) and financial crisis of 2007 (Rodgers et al., 2012), this paper examined the

behavior of thrift banks on how they manage their excess reserves during the crises and in

normal times.

Moreover, this paper adapted the model of Dow (2001) and included only the demand

deposit and interest rate as an opportunity cost of holding excess reserves to give precise analysis

on the behavior of thrift banks toward their reserve management. The researchers however

excluded the other explanatory variables from Dow such as the required reserve balances and the

demand factor observed by the open market desk in the U.S. since they were not part of this

study.

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Knowing how these factors: demand deposits, opportunity cost of holding excess reserves

(interest rates) and uncertainties (Asian and Global Financial Crises) affect the level of excess

reserves, can help the thrift banks to evaluate their reserve management as well as the Bangko

Sentral ng Pilipinas in implementing monetary policies. This could also help future researches

about reserves since this will be the first study of excess reserves in the Philippine setting.

Furthermore, it is important to take note and not to be confused that this paper only

discussed the fractional reserves of banks and not the gross international reserves of the country

as a whole, which includes foreign currencies and gold reserves. The data on excess reserves was

confined only from thrift banks which exclude other types of banks such as commercial and

universal banks. For the reason that the current literature on excess reserves was more focused on

big depository institutions (DIs) such as the commercial universal banks, this paper however

wanted to explore the situation of small DIs such as thrift banks because thrift banks have a

relatively small capital and therefore more prone uncertainty risks.

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Review of Related Literature

Bank Reserves

Under the fractional reserve system, each deposit made to the depository institutions are

subjected to a legal requirement which individual banks have to comply with. Bank reserves are

funds which are kept by banks, in order to meet the central bank’s statutory reserve requirement.

Similar to the United States, these reserves can be held either as cash balances in individual

banks’ vaults or deposits in the central bank. Reserves subject to the legal requirement are known

as required while the additional reserves are called excess (Taufemback et al., 2012).

Management on the supply of reserve balances is important in the operation of U.S. monetary

policy (Judson et al., 2011).

The main monetary instrument applicable for maintaining a level of reserve is the

manipulation of the reserve requirements by the central bank. Faig et al., (2008) and Jalbert et

al., (2010) both researchers justify the use of reserve requirements as a channel to regulate the

money supply in order to stimulate the economy. Lown (2003) considers reserve requirement as

“tax” on banks for holding reserves which are not interest earning. In this case, banks prefer to

have low reserve requirements in order to free more funds for and invest them into earning

assets.

In the banking literature, reserves have been considered as an instrument to manage the

risk of facing uncertainty of withdrawals from depositors (Faig et al., 2008). In the case of

extreme uncertainty, a central bank may opt to use reserve requirement to strengthen the health

and stability of financial institutions during an economic downturn or crisis (Jalbert et al., 2010).

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Excess Reserves

The Reserve Position Doctrine (RPD) as a monetary policy deals with the manipulation

of the level of excess reserves via open market operations. Although most banks now are shifting

away from RPD and adopting interest rate targeting, there is still an ample space in the textbooks

about it which is popularly known as the money multiplier. In the European Central Bank (ECB),

excess reserves are still used as the framework in their monetary policy (Bindseil et al., 2006).

Excess reserves are the incidental accumulation of liquid reserves held by banks.

Although there are some banks which prefer to hold more reserves more than what is required to

satisfy unexpected withdrawals (Agenor et al., 2004) from depositors or which we will consider

as uncertainty. Whenever a bank fails to meet the legal requirement they are penalized by the

central bank. To avoid overdraft or penalties on reserve deficiencies, banks wanted to hold more

reserve balances. Likewise, more excess reserves provides less risk for bankruptcy in case of

bank runs but it provides an opportunity cost of lower profits because of reduced loanable funds

(Taufemback, 2012).

This was also supported by Ashcraft (2011) that excess reserves are held because either

no bank can trade after payments shocks occur, payments shocks are withdrawn from the

banking system, or there are autonomous shocks to the supply of reserves held by banks that the

Fed does not fully offset. Reserve balances are used by banks to meet legal requirement and to

settle payments, if they fall short on liquidity they may opt to borrow in the interbank market and

lend excess, if they have any to other banks who are overdraft (Fullwiler, 2006).

According to Cargill (2006), banks hold excess reserves because of the fear of bank runs

as learning from their experience in the Great Depression of 1930 – 1933. Also, there has been

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an excessive supply of reserve balance in the credit crunch of 2008 and it continued to be

remarkably high as compared to previous levels (Judson et al., 2011). But contrary to the

arguments above, banks minimize excess balances holdings as stated since they earn no interest

(Demiralp, 2005). Dow (2001) stated that banks want to hold reserves to avoid overdraft or

reserve deficiency penalties on their account at the central bank when facing uncertain flows of

funds.

Demand Deposits

Dow (2001) used demand deposit in his model to determine the level of excess reserves.

He stated that excess reserves have increased with the growth of deposits. Truly, the findings of

his paper showed that an increase of deposit of $1 billion corresponds to an additional $3 million

of excess reserves. Moreover, Lown et al., (2003) said that the possibility of reserve drains

really depends on the demand deposit losses as well as for time deposits. They then concluded in

their work that deposits were really used by banks to determine their reserve position.

Ogawa (2007) supported through his estimation results that deposits exerted a

significantly positive effect on reserve holdings. However, he did not

emphasized much on deposits rather more on the financial health of the

banks and the interest rates set by the central bank.

Skeie (2008) added to the literature that through his model large withdrawals of demand

deposits can exhaust banks’ excess reserves. Further, he also emphasized on demand deposits’

effect on banks’ liquidty and bank run. He stated in his study that the central bank creates a fiat

currency that it uses to buy and sell goods and services at a fixed price. In his study he measured

demand deposits in real terms and currency in circulation withdrawals rather than nominal terms

of those that is based on the fiat currency. He used it to know how those variables affect excess

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reserves or liquidity that in turn cause bank runs and liquidity crises. He added that literature

provides that bank runs are caused by withdrawals of demand deposits payable in real goods that

exhausts in the banking system a fixed reserve of goods. The framework describes a traditional

bank run in US and recently developing countries where it is based on currency in circulation

withdrawals. In contrast, large withdrawals usually are in electronic payments of inside money

without affecting a depletion of a scarce reserve from the banking system. Furthermore, Skeie

(2008) included in his study that in a closed economy with no central bank intervention or in the

absence of regulation and other policy influence, bank reserves are not exhausted from the

banking system unless currency is withdrawn and stored outside of the system.

Skeie (2008) also included in his study that large withdrawals drain excess liquidity and

liquidity reserves present in the banking system. He added that regardless of the trigger,

depletion of fixed liquid real goods reserve present to be paid out from the system of banking is

caused by excessive withdrawals. To provide to these short term payouts, long term investments

have to inefficiently liquidate. Because of this inefficiency, all depositors will try to withdraw

immediately knowing that bank will not be able to pay all future withdrawals. A bank run in a

real deposits framework will still happen even if the bank is fundamentally solvent for the reason

that the liquidity structure of short term liabilities and long term assets are fragile.

Teles and Zhou (2005) added that retail sweep programs that reclassify demand deposits

to savings account affect the exhaustion of reserve balances. He added that since 1994, banks

reclassify back their demand deposit accounts when its low from their previous reclassification

of demand deposits balances above a certain level. For these reason, the study found out that the

portion reclassified in the demand deposits led to the avoidance of reserve requirements and

holdings of reserves by banks. The study of Duca and VanHoose (2004) emphasized that the

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recent increasing swept demand deposit balances led to a weaker link between demand deposit

and liquidity. In effect, their paper stated that adjustments in M1 would be optimal so that

monetary policies can consider these swept balances and for banks to hold the optimal reserve

requirements.

In the study made by Dutknowsky and VanHoose (2011), they focus on how demand

deposit sweeping can affect the excess reserve holdings. They added that the excess reserve

holdings of banks make uniformly less responsive to exogenous changes in interest on loans or

reserves, required reserve ratio, bank deposits, or equity because of swept demand deposits. They

supported these findings through the study of that Anderson and Rasche (2001), which stated

that sweeping decreased required reserves.

In addition, Baoteng (2013) further explained in their study on reserves of China that

deposit shortage, reserve adjustment cost, reserve inventory cost and reserve readiness for rent-

seeking opportunity would trigger the need for banks to hold excess reserves. They also found

out in their work that the fail in deposits led to the reduction in credit supply. They explained that

this was because banks face higher external finance cost to substitute deposits thus banks’

lending channel occurred via the money multiplier mechanism in China. They added that the

shift of excess reserves to precautionary category led the involutary excess reserves to fall. This

led to decreases in demand deposits that also led banks to face market frictions in substituting

deposit shortfall with other non-reservable liabilities that cause them to reduce lending. With

this, it is likely that banks would be less responsive to tightnening monetary policy if they hold

larger involuntary excess reserves. They added that this is in contrast to banks in emerging

market economies. Further, these involutary excess reserves can buffer for the effects of

monetary policy shocks. In addition, a pivotal role can be played in bak lending behavior of

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banks in monetary policy effectiveness and transmission mechanism to excess reserves beyond

precautionary levels. They supported their findings through the study of Acharya and Naqvi,

(2012), which stated that exacerbate risk-taking behavior and aggressive bank lending can result

from significant amount of involuntary excess reserves that showed a low probability of liquidity

shortage.

H1: Demand deposit has a direct relationship to the level of excess reserves.

91-Day Treasury Bills Rate

Dow (2001) observed the demand of excess reserves from 13 large banks using one-

month Treasury Bills rate as an opportunity cost. His finding is that an increase in the Treasury

bill rate tends to decrease excess reserves by $150 million. Bindseil et al. (2006) said, in support

of the proposition of Dow, that if there is an increase in the level of interest rates, there will also

be a decrease in the level of excess reserves. He revealed that a deposit institution with an

interest rate of 2.25%, the opportunity cost and in this case loss of all banks in the euro area to be

around €15 million per year, and a slightly lower loss of €100,000 for individual banks.

In the case of Japan, Ogawa (2007) examined a panel data on Japanese banks in the

period of 1991 to 2002. He found that the optimal demand for excess reserves is a decreasing

function of short-term interest rate or call rate. The results of his study confirm that there is a

significant impact between interest rate as well as banks’ financial health on the demand of

banks’ reserves. In quantitative terms, he observed that an increase of .25% in the call loan rate

contracted the aggregate excess reserves by 55–70%.

Whitesell (2006) also recognizes interest corridor as an opportunity cost in holding

reserve balance (hence excess reserves). Agenor et al., (2010) identifies the bond rate as the

opportunity cost of excess reserves which also implies a negative relationship. In his model, he

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considers the optimal holding of reserves balances are determined by the following cost

minimization dilemma, in which the bank must balance against the opportunity cost of holding

reserves.

Likewise, Marquez et al., (2013) included in his model repo rate, Eurodollar rate and

discount rate to have an inverse relation with excess reserves. He anticipated that if the increase

of short-term interest rates rises faster than the increase in deposit rates, then the opportunity cost

in maintaining reserve balances increases as well.

According to Lown (2003), there is no significant difference between required and excess

reserves in terms of practicality for the reason that banks treat them for the same purpose.

Discussions in his paper stated that in 1873 to 1929 and after 1953 banks had lower reserve

requirements which followed the increases in interest rates. The findings of his paper suggest an

inverse function between interest rates and reserve requirement and therefore to excess reserves

as well. 

However, Keister et al., (2006) noted that if the central bank began paying interest on

reserves equal to the market interest rates then it removes the opportunity of cost of holding

reserves. Thus, the researchers formulated the hypothesis of 91-day Treasury bills rate as an

inverse function or an opportunity cost to excess reserves.

H2: 91-treasury Bills rate has an inverse relationship to the level of excess reserves.

Crisis

Mitchelle (1941) viewed financial crises as when depositors have the grounds to believe

that the economy in the near future looks poor. With that said, the depositors would anticipate

that future loan defaults will make it impossible for the bank to repay their deposits thus they

will withdraw their money now.

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There are two traditional ways of understanding crises. The first is that crises result from

panics. Secondly, crises arise because of fundamental causes from the business cycle. Friedman

and Shwartz (1963) and Kindleberger (1978) argued as well that banking crises were resulted

from panics and that most banks closed because they were illiquid rather than being insolvent.

Financial systems have been so interconnected wherein the differences between banks

and non-bank institutions have been blurred by rapid development of off-balance-sheet activities,

credit derivatives and various non-bank financial intermediaries. Thus, once a large bank is near

the cliff of collapsing, the whole system would be hurt thru spillover effects and negative

externalities which could trigger systematic crisis (Mingkang, 2011).

Talasli (2010) emphasized in his work that the uncertainties in the economy or banking

system of Turkey would lead to an increase in the level of excess reserves. He included dummy

variables that captured the effect of some liquidity shocks like quarter ends, public and religious

holidays, when the increase in the volume of currency in circulation causes negative liquidity

shock, tax payments, treasury auction settlement days and salary payments. These were the days

of high payments of flows through banks’ reserve accounts and therefore represented as an

uncertainty. In addition, he also put stressed that the increased distress in the global money

markets after Lehman’s collapse caused Turkish banks to demand high levels of excess reserves.

Moreover, Judson et al. (2011) supported the work of Talasli that demand for excess reserves

depended critically on uncertainty of flows in and out of reserve accounts (Judson and Klee,

2011).

This uncertainty was further explained by Agenor, Aizenman and Hoffmaister (2004).

They said that the increased incidence of rationing may take the form of increases in excess

reserve holdings motivated by higher perceived uncertainty or risk of default. And they further

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emphasized that greater volatility of deposits and increased riskiness of lending may also prompt

banks to hold higher levels of precautionary excess reserves.

Cukierman (2013) explained in his work that a dramatic increase in the amount of excess

reserves occured in the United States during the global financial crisis. The annual long-term

normal rate increase between January 1999 and August 2008 is about half a percent. After the

Lehman event and up to april 2011, the anual rate accelerated to 100% that showed the rush of

US Banks to accumulate reserves after September 2008. And at the end of August 2008, he

emphasized that the total banking reserves stood at about $ 46 billion and just a year later, it

increased by eighteen times larger.

Krishnamurthy (2011) added that there is also a heightened demand for reserves during

crisis. Krishnamurthy also noted that the Federal Reserve’s policy tools were less effective

during such. The interbank market for liquidity is also widely thought to have functioned poorly

during some of the most stressed periods of the financial crisis in 2007 and 2008. Liquidity,

demand and hoarding phenomenon was rampant across many market suggests that broad factors

were at work during the crisis.

Haan and End (2013) also had the same findings with that of the works above. They

found out that crisis had negatively affected liquid asset holdings against liquid liabilities. This

reflected the fact that the level of demand deposits was relatively unaffected during the crisis.

They explained as well that it could also be that the extended liquidity support by their central

bank might have been an incentive for banks to reduce their liquidity buffers.

Contrary to the literature above, Murta and Garcia (2010) did not find any significance in

the existence of a crisis with the level of excess reserves. They strongly argued that they did not

find evidence of changes in the demand for excess reserves by European banks after of the

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beginning of the subprime credit crisis. However, he also added that through ECB’s

implementation of several measures, the crisis was softened in the money markets. Thus, their

study strongly contributed to the understanding that, in a banking sector where the central bank

contributes to minimize the impact of a crisis that affects the operations of the banks and

contributes to the reduction of uncertainty, the credit institutions must rather focus on the cost of

obtaining reserves in order to minimize its level.

Asian Financial Crisis

Initially, the depreciation of Thai Baht lead to the financial crisis experienced by

Southeast Asia and East Asia during 1997 – 1998 and soon reached other economies because of

financial contagion. In the beginning of the crisis, Thailand was already experiencing debt crisis

which was worsened by the depreciation of Thai Baht. The crisis rooted from fast growth of

inflow on speculative cash to the Southeast Asia that resulted to the increase of asset prices and

blown up asset markets. Speculative cash inflows were attracted by open minded economists in

the region. When the investors got knowledgeable of the risks involved in their investments, they

immediately withdrew their money, resulting to Southeast Asian economies to be pressured and

drove them deeper into crisis. (Havertz, 2012)

During the Asian financial crisis, there was an uncontrolled fluctuation in the interest

rates, asset prices and exchange rates. There was an increase in the non-performing loans (NPL)

because of very high interest rates which lead to corporate failure. Over-lending of banks,

financial deregulation, weak banking supervision and cronyism were the other factors which

were identified to have caused the crisis (Aslam, 2012).

One of the root causes of Asian financial crisis was the moral hazard problem. To

explain, insurance scheme is needed in the banking system but it creates this so called moral

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hazard problem. This moral hazard problem has been even more complicated by the

development of financial systems. The banking system for example has shifted from a credit

culture to an equity culture –the income of banks have shifted from simply providing loans to

securing them and the funding of banks has changed to capital markets, that relies mainly on

others foreign investments resulting to large amount of embedded leverage (Hoflich, 2011).

Global Financial Crisis

To derive money from lending activities, banks issued more securities. As a result, new

financial instruments known as money market derivatives were created and traded in an

unstructured and unregulated market i.e. over-the-counter (OTC). Because it is new to the

market, leveraging in these financial instruments has increased and the government and market

do not understand the kinds of risks and what would these entail in the economy. Further, these

financial instruments lack transparency. These results to government and market’s inability to

accurately determine the value and volume of these derivatives traded over-the-counter. The

foremost buyers of financial instruments are investment banks and other financial institutions

with excessive idle funds.

The too big to fail (TBTF) problem rooted from the excessive risks taken by large banks.

These risks allow large banks to externalize their costs thus pressuring the government to bail out

failing lenders. With that said, the focus should be in the part of the regulators. They should

monitor the risky investments made by the large banks or they should make advance measures to

supervise the high risk large banks. Large banks significantly contributed to the existence of the

global financial crisis.

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H3: Crisis has a direct relationship to the level of excess reserves.

Liquidity

One of the main issues being discussed in this paper was the liquidity. Banks have liquid

liabilities and illiquid assets. They borrow short and lend long. This makes banks vulnerable to

sudden demands for liquidity or the so called bank runs. Individuals have preferences for

liquidity but the most profitable investment takes a long time to pay.

One observation during the financial crisis was the problem in liquidity. Problems like

balance sheet constraints, poor transparency regarding potential losses and concerns about

concerns about counter party risk contributed to an illiquid financial market. Another problem in

the liquidity management was the unwillingness of largest financial institutions to lend to each

other because they are concerned about the solvency risk and the opaqueness of firms.

(Rosengren and Werkema, 2011)

Liquidity lock described as extreme risk aversion by many financial institutions that lead

to continuous accumulation of illiquid assets. These institutions feared that they would not be

able to sell assets in time without steep discounts.

The dilemma is that depositors or consumers do not have a clear knowledge of the timing

of their consumption in the inception of investment decisions. If a depositor put his investment

on short-term asset and that he needs his funds in a later date, the depositor will regret that he did

not put it in higher- yielding long-term asset that would maximize his income. If, on the other

hand, a depositor put his investment on long-term-asset and that he needs his funds in an earlier

date, he will have no funds to support his consumption and will regret not putting it in short-term

asset. Even if the depositor invests in a combination of the two asset, the depositor will still

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regret with positive probability. This mismatch of asset maturity and time preferences is the

problem that banks must find solution.

On the other hand, liquidity has a key role in determining asset prices. The supply of

liquidity is determined by banks’ initial portfolio choices. Nevertheless, small uncertainties to the

demand for liquidity cause a collapse in asset prices. Once supply of liquidity is fixed by banks’

portfolio decisions, shocks to the demand for liquidity can result to asset-price volatility and

default. In the short run, supply of liquidity is fixed. Moreover, in the absence of default, the

demand for liquidity in the short run is perfectly inelastic. If the banks’ supply of liquidity is

enough to satisfy the depositors’ demand when preference for liquidity is high, thus, there should

be an excess supply of liquidity when their preference is low. A low interest rate would imply

that asset prices are correspondingly high. However, asset prices cannot be high in all states for

then short asset would be dominated and therefore, no one would want to hold it. Basically, in

the absence of default, there will be price volatility. This argument does not require large shocks

or uncertainties to liquidity demand.

Synthesis

After all the reviews made, the researchers have found out that there is lacking of journals

from the Philippines which could support the topic of this paper. All of the reviews were from

the journals of other countries such as U.S and other European Countries. With that, the

researchers considered this as a gap and decided to adapt the models of these researchers and

apply it to the Philippine setting. But it is important to take note that the models are modified

base on the financial, economic and existing policies in the country as well as the availability of

data from the central bank.

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The works of Dow (2001), Lown et al., (2002), Ogawa (2007), Skeie (2008), Duca et al.,

(2004), Dutkknowsky et al., (2011), Teles et al., (2005), and Baoteng et al., (2013) all observed

the level of demand deposits and excess reserves. All studies proved a significant positive

relationship between the level of demand deposits and excess reserves. The work of Dow (2001)

focused its study on the US setting. The study of Lown et al., (2002) emphasized reserve drain

on time deposits and demand deposits. Ogawa (2007) noted the effect of the two variables to

interest rate and financial health. The paper of Skeie (2008) highlighted the effect of the two

variables in bank’s liquidity and how large withdrawals affect demand deposits and excess

reserves. Works of Teles et al., (2005), Duca et al., (2004), and Dutkknowsky et al., (2011)

focused on the effect of retail sweep programs to demand deposits and excess reserves. Baoten et

al., (2013) highlighted how the money multiplier effect in China was affected by the excess

reserve and demand deposits and noted that the deposit shortage, reserve adjustment cost, reserve

inventory cost and reserve readiness for rent-seeking opportunity triggers excess reserve

holdings.

The works of Dow (2001) in the U.S., Bindseil et al., (2006) in the Euro area and Ogawa

(2007) in Japan are similar when they observed the behaviour of excess reserves and interest

rates. Both papers proved the inverse relationship between the two variables. Whitesell (2006) as

well as Agenor et al., (2010) identified interest rates as the opportunity cost of holding more

excess reserves which also supports the negative relationship as stated by the previous authors.

Marquez et al., (2013) included in his model repo rate, Eurodollar rate and discount rate to have

an inverse relation with excess reserves. Lown (2003) proved that interest rate is negatively

correlated with required reserves which also translates to excess reserves. Keister et al., (2006)

said that if ever the central bank equates the interest rate paid on reserves and market interest

22

rate, then there will be no opportunity cost faced by the banks. Thus, the researchers formulated

the hypothesis of 91-day Treasury bills rate as an inverse function to excess reserves.

Talasli (2010), Haan and End (2013), Krishnamurthy (2011), Cukierman (2013), Agenor

et. al. (2004) and Judson et. al. (2011) found out that crisis also affect the level of excess

reserves. However, Marta and Garcia (2010) did not find any significance in the existence of

crisis to level of excess reserves in the European area. Thus, the study would like to find out if

crisis is significant in the Philippines in determining the level of excess reserves.

The related literature and studies have almost similar insights and facts gathered about

the subject matter. The current study as compared to the related literatures and studies do have

almost same goals or objectives in determining the effects of t-bills rate, demand deposits and

crisis to the demand for excess reserves of the banks. The researchers understood that this study

is going to be very significant in contributing to the pool of information about the behavior of

banks in the Philippines with regards to their demand for excess reserves. This research is

believed to be a guide for other future researches and the results of this paper can be used by the

authorities to make monetary policies.

23

An Analysis on the Incidence of Excess Reserves: Case of the Philippines

Figure 1. Research Simulacrum

s

1

0

1

0

Demand Deposits

91-day Treasury Bills Rate

Asian Financial Crisis

Excess Reserves

(+)

(+)

(-)

Global Financial Crisis(+)

24

Research Method

Research Design

The study used quantitative approach and time-series data. The study considered

quantitative approach since the data used were about the reserves of the banking system and the

factors that affect them, which both were in terms of peso and percentage. The study used time-

series data because excess reserves of the thrift banks and 91-day treasury bills rate of the

country are all available in monthly terms and the impact of Asian Financial Crisis of 1997-1998

and Global Financial Crisis of 2007-2008. The researchers wanted to find out if a change in each

explanatory variable would cause a significant change to the dependent variable.

The research was a national study because it covered all the thrift banks of the

Philippines. This also covered the data from 1990 to 2010 monthly. The rationale of choosing the

period was that the researchers would want to know the behavior of the banks toward their

excess reserves from the beginning, development and aftermath of the financial crises. The

researchers used the Consumer Price Index (CPI) to deflate the quantitative variables in the

model and used the CPI in 2006 as the base year, which is the current base year set by the

National Statistical Coordination Board (NSCB). The deflation of the quantitative variables

made them more comparable since from nominal terms, they were converted to real terms that

excluded the effects of inflation and other noise related to data being in nominal terms.

The research used two binary dummy variables to represent the two crises, namely the

presence of the Asian Financial Crisis and the presence of Global Financial Crisis. For the two

binary dummy variables, 0 represented the absence of the crisis and 1 represented the presence of

the crisis.

25

The research used the Ordinary Least Squares (OLS) method to test the magnitude, and

the effects of each explanatory variable to the dependent variable. To interpret the model, the

researchers will use the following tests: Student’s t-test and Analysis of Variance F-test to test

the significance of the explanatory variables and the significance of the model.

Data Collection Procedure

The data needed were excess reserves, demand deposits and 91-day treasury bills rates.

All the data were available and gathered from the database of the Economic and Financial

Learning Center of the Banko Sentral ng Pilipinas.

Data Analysis

The purpose of this section was to develop an empirical model that can examine the

effects of change in demand deposit, treasury bills rates, the Asian Financial Crisis, and the

Global Financial Crisis on the level of excess reserves. Dow (2001) did a research on the demand

of excess reserves on which he specify four variables that affects the excess reserves. These

variables are opportunity cost of holding excess reserves (overnight interest rates), level of

transaction deposits, level of required reserve balances, and the demand factor observed by the

desk. Using these variables, Dow (2001) demonstrates that through these variables an estimable

equation can be generated. Furthermore, the model that he used was parsimonious and testable.

A number of problems arose from this research approach. Among these were errors in

measurement and multicollinearity associated with demographic data. Despite these potential

problems, there must be some starting point for empirical research into the process by which

business knowledge is learned.

The choice as to what demographic variables to include in the model presented several

difficulties. The researchers adapted the model of Dow (2001) only that the researchers dropped

26

the demand factor observed by the desk. Instead of having the level of required reserve balances,

the reseachers replaced it with the Asian Financial Crisis and Global Financial Crisis factor to

lessen the possibility of multicollinearity in the model, specifically the multicollinearity between

deposits and required reserve balances. While other authors have found a significant relationship

between excess reserves and the following variables: penalty rate, interest spread, overnight call

loan rate and interbank call loan rate, sweep accounts, level of loans, cost of borrowing, and

interbank market, the terms were not significant in this study. Inclusion of these variables into

the model increased the possibility of multicollinearity among variables, increased the noise in

the model rather than fit, and deviates from the objective of the study. For these reasons they

were not included in the model.

The model developed to analyze the level of excess reserves relied on a the effects of

change in demand deposit, 91-day treasury bills rates and the Sub-Prime and Global Financial

Crisis, which can be represented by an equation of the form:

(Eq.1)

ExRes=β0+β1 LogDemDep+β2 DLogTBillst +β2 DLogTBills t−1+DAsian+DGlobal+ε

where ExRes measures the level of excess reserves, β0 as the value of the level of excess

reserves without the effects of other variables, DemDep as the level of demand deposits, TBills

as the treasury bills rate in the market, DAsian as a dummy variable to indicate the effect of the

Asian Financial Crisis, DGlobal as a dummy variable to indicate the effect of the Global

Financial Crisis, and ε as the residual term.

The model measured the level of excess reserves as the difference of the actual reserve

holdings of thrift banks, which includes cash in bank’s vault, deposit balance with BSP, eligible

domestic securities, eligible foreign securities, and government securities under repurchase

27

agreements and the required reserve balances the banks must hold, which includes statutory or

regular reserves and liquidity reserves. The level of demand deposits was measured by the actual

amount of checkable deposits thrift bank holds. Both excess reserves and demand deposits were

measured in million pesos.

The model used a semi-log functional form because of the established relationship of the

explanatory variables to the explained variable. The model included a time lag of 1 for 91-day

treasury bills rate to take into account the maturity of the treasury bills. The model used the first

difference for the treasury bills rate to account the usual volatility of interest rates and to make

the variable stationary.

28

Data Presentation and Analysis

Regression Output

Dependent Variable: EXRESMethod: Least SquaresSample (adjusted): 3 252Included observations: 250 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

C -2316.240 546.7068 -4.236713 0.0000LOG(DEMDEP) 312.5887 60.49344 5.167317 0.0000DLOG(TBILLS) -393.7842 546.4726 -0.720593 0.4718ASIAN -807.2772 237.5003 -3.399058 0.0008GLOBAL 999.6082 307.4210 3.251594 0.0013DLOG(TBILLS(-1)) 1453.029 683.5727 2.125639 0.0345

R-squared 0.218500     Mean dependent var 476.4656Adjusted R-squared 0.202486     S.D. dependent var 1081.417S.E. of regression 965.7445     Akaike info criterion 16.60738Sum squared resid 2.28E+08     Schwarz criterion 16.69190Log likelihood -2069.923     Hannan-Quinn criter. 16.64140F-statistic 13.64405     Durbin-Watson stat 1.714698Prob(F-statistic) 0.000000

Table 1

Interpretation

Based on the regression system, the total excess reserves of thrift banks in the Philippines

would contract by 2316.240 pesos (in millions) in the absence of demand deposit, 91-day

Treasury Bills rate and crises. The excess reserves would increase by 312.5887 pesos (in

millions) for every one percentage increase in the demand deposit. While treasury bills rate is

insignificant at level, it is significant after by lagging it by 1. The excess reserves would then

increase by 1453.029 pesos (in millions) for one percentage point increase in treasury bills rate.

29

Since the data range is from 1990 to 2010, two financial crises were captured namely the

Asian Financial Crisis and the Global Financial Crisis. During the Asian Financial Crisis, thrift

banks significantly decrease their excess reserves by 807.2772 pesos (in millions).While in the

Global Financial Crisis, thrift banks significantly increased their excess reserves by 999.6082

pesos (in millions).

Analysis

Demand Deposit

The result obtained from the regression shows that the demand deposit is significant at t-

Statistic Probability of 0.0000 which is less than α, level of significance of 0.05 and it has a

positive relationship with excess reserves. A percentage increase in demand deposit would lead

to an increase of 312.5887 pesos (in millions) in the excess reserves. This is consistent with the

hypothesis of the researchers and from the works of Dow (2001); Lown et al., (2003); Ogawa

(2007); Skeie (2008); Duca et al., (2004); Dutknowsky et al., (2011); Anderson et al., (2001);

Boateng (2013).

Demand deposits are subjected to statutory requirement set by the Bangko Sentral ng

Pilipinas (BSP). A portion of the reserves are kept inside the vaults of the individual thrift banks

and the remaining is deposited at the BSP. It is logical to say that as the demand deposit

increases, there will also be an increase in the excess reserves since there will be more available

reserves that can be held.

The monetary base is composed of the money supply plus the total reserves. Excess

reserves are also part of the monetary base but since it is part of the reserve, it cannot be loaned

out by the banks thus, it is not part of the money in circulation. If there are more excess reserves,

30

it means that there are more money that are kept in the banks’ vaults or in the BSP’, therefore,

there is less money that can be loaned and less currency in circulation.

However, in the context of thrift banks, thrift banks have relatively significant lower

reserve requirements compared to expanded commercial banks and commercial banks due to

their relatively lower capital. With this, it is also logical to say that the accumulation of excess

reserves would make their demand deposit accounts secured as those of demand deposit accounts

with expanded commercial banks and commercial banks. Furthermore, accumulation of excess

reserves would not only make the thrift banks to make their demand deposits security to bank

systemic shocks but also it would give them interest income due to the interest given by BSP to

excess reserves. Because of these benefits to thrift banks in just one financial instrument, these

would give them more incentive to accumulate excess reserves as demand deposit increases.

It is also logical to say that as demand deposit increases, so as the degree of uncertainty

related to withdrawal of depositors increases. Since these demand deposit accounts can be

withdrawn anytime it gives relatively higher degree of uncertainty compared to other deposit

accounts maintained in banks. If this degree of uncertainty would not be lessened, it would

cripple the banks’ ability to optimize their investment and loans. This effect would be greater in

the case of thrift banks since thrift banks have relatively lower capital compared to expanded

commercial banks and commercial banks and because of that thrift banks have more incentive to

optimize their investment and loans to extract more profit in those financial instruments for them

to be able to compete with all other banks with relatively higher capital. One way for thrift banks

to reduce this increase in uncertainty related to increases to demand deposit is to maximize the

accumulation of excess reserves. For the reason that increases in accumulation of excess reserves

would give relatively lower degree of uncertainty and risk compared to other investment

31

instruments and give out loans but will yield the relatively greater interest income. Furthermore,

because of accumulation of excess reserves would give relatively lower uncertainty risks thrift

banks would have greater incentive for them to hold reserves. Because of these reasons, an

increase of demand deposits will also increase excess reserves.

91-Day Treasury Bills Rate

Based on the regression system, treasury bills rate at level is insignificant at t- Statistic

Probability of 0.4718 which is greater than α, level of significance of 0.05. But at lagged 1 of the

treasury bills rate, it has been found to be significant at the t- Statistic Probability of 0.0345

which is less than α. A percentage increase in the treasury bills rate would increase the level of

excess reserves by 1453.029 pesos (in millions). This is a contradicting result to the hypothesis

of the researchers of a negative relationship between excess reserves and the treasury bills rate

and also to the works of Dow (2001); Bindseil et al., (2006); Ogawa (2007); Whitesell (2006);

Agenor et al., (2010); Marquez et al., (2013); Keister et al., (2006); and Lown et al., (2003).

The lagged term of 1 signifies that the thrift banks will not immediately respond to a

change in the treasury bills rate until a month after its official release. This may be explained by

the treasury bills rate used in the model which is the 91-day Treasury Bills rate. Since, its

maturity is three months after its purchase, the change in the treasury bills rate will not affect the

treasury bills purchased previously. Thus, purchasing treasury bills requires proper timing and

forecast of a change in its rate before a bank would invest on new treasury bills.

To appropriate funds a period of time before purchasing a treasury bills would not be

optimal since the funds allocated will be idle and hence will not earn interest or will not increase

32

the capital or assets of a bank. It would then be a wise option for banks to put it on reserves to at

least earn interest, assuming these funds are the excess funds after all the banking operation.

It is in BSP’s discretion on whether they will put a 4% interest per annum on statutory

reserve but only up to 40% of the total level of statutory reserves and the other option is given to

thrift banks to shift their reserves to liquidity reserves which are in form of market-yielding

bonds purchased directly in BSP. The whole balance of thrift banks in liquidity reserves will be

given half of the market interest rate of the prevailing government securities which is the

treasury bills rate. However, in 2006, BSP amend its policy of instead of banks purchasing

market-yielding bonds, they will instead deposit directly to BSP. This is in form of Reserve

Depository Accounts (RDA). These RDAs are short-term deposits and may be in form of 3, 6

and 12 month term deposit. These deposits have interest rates of half of the prevailing

government securities.

Furthermore, according to Hornstein (2010), “if the federal funds rate is below the

penalty rate but above the interest rate paid on reserves, then the forgone interest income

represents an opportunity cost to holding reserve balances. However, if the federal funds rate is

equal to the interest on reserves, then there is no opportunity cost to holding reserves and the

demand for excess reserves becomes infinitely elastic” that is in the case of the United States. In

the Philippine setting, considering the mechanism provided by Hornstein (2010), if the interbank

call loan rate and overnight rate, which is also the reference for treasury bills rate, is less than the

penalty rate set by the BSP and the interest on reserves then there will be no opportunity cost, but

rather banks would prefer to place it on reserves because of the fear of overdraft and higher

interest income.

33

Since the interest paid on statutory reserves is at 4% per annum, it is greater than the

usual interest rate provided by the treasury bills. It does not motivate banks to invest on treasury

bills and would rather prefer placing it in reserves since the opportunity cost of these funds not

placing in excess reserves is greater than when it is placed in excess reserves.

However, it is also logical to say that one reason why the response in excess reserves of

thrift banks comes after only a month after a change in 91-day treasury bills rate is that thrift

banks have in their investment portfolios treasury bills with different time of maturity. 91-day

treasury bills purchased in different months would significantly affect the decision of thrift banks

to invest or accumulate excess reserves given their relatively lower capital. This is for the reason

that these treasury bills would also qualify as conforming to the reserve requirement set by BSP

under their liquidity reserve policy. Furthermore, since they have lower capital they would still

wait for a certain number of treasury bills to mature to get their interest income and their funds

for them to use it in their operations. Since a change in treasury bills rate would reflect on the

interest on reserves, it would also affect the decisions of thrift banks to invest in excess reserves.

It may be noted that the more the variation in maturity in thrift banks’ current 91-day treasury

bills, the more the thrift banks would delay their operations and holding of excess reserves.

In addition, in the context of thrift banks, there will be greater incentive to find the

optimal combination of treasury bills and other investment channels and accumulation of excess

reserves due to their relatively lower capital compared to other banks. Since thrift banks have

relatively lower capital they have greater incentive to manage their opportunity costs and

benefits regarding their investment portfolios.

34

It is logical to say that one reason why the response in excess reserves of thrift banks

comes after only a month after a change in 91-day treasury bills rate is that they want to

maximize their investment decisions through comparing prevailing treasury bills rate, previous

treasury bills rate, and average treasury bills rate. Furthermore, if the change in treasury bills

rate, which is the difference of the prevailing treasury bills rate and previous treasury bills rate,

would be relatively lower than the average treasury bills rate thrift banks would rationally put

their funds in other financial instruments rather than the treasury bills rate. This is for the reason

that the marginal change in treasury bills would not be enough to compensate for the opportunity

costs the thrift banks would incur if they will invest in treasury bills. In effect, since interest on

reserves are based also on treasury bills thrift banks will also do the same which is to not

anymore hold excess reserves. In the context of assessing risks, if the interest on excess reserves,

which are based in treasury bills rate, would give a lower interest income compared to the

income other financial instruments would give but with higher risks, it would affect the thrift

banks decision on to optimize the income return from investments and risks related to those

financial instruments. Because of these reasons, and increase in 91-day treasury bills rate would

increase excess reserves a month after the change in 91-day treasury bills rate.

Crises

Uncertainty is one of the main reasons why banks are motivated to hold reserves.

Furthermore, anticipation of a great uncertainty would entail having to hold reserves greater than

what is required to absorb its effect to the financial system. In the case of the Philippines, there

are two major financial crises namely, the Asian Financial Crisis (1997 – 1998) and the Global

Financial Crisis (2007 – 2008). The researchers isolated the two crises and observed the behavior

of the banks’ excess reserves on the separate crises.

35

Asian Financial Crisis

The regression system analyzes that the Asian Financial Crisis is significant at t- Statistic

Probability of 0.0008 which is less than α, level of significance of 0.05 and negatively related to

the level of excess reserves. The presence of Asian Financial Crisis contracted the level of excess

reserves to 807.2772 pesos (in millions). The result is inconsistent with the hypothesis of the

study and to the works of Krishnamurthy (2011); Judson et. al., (2011); Agenor et. al., (2004);

Bech et. al., (2011); Cukierman (2013); Haan et al., (2013); and Talasli (2010). that an existence

of crisis varies positively with excess reserves.

The result implies that during the Asian Financial Crisis, instead of hoarding a massive

level of excess reserve, thrift banks did not constrain the liquidity of the financial system. This

follows the advice by the Fed that a large increase of excess reserves during a crisis will be

ineffective (Keister et. al, 2009) in resolving the credit crunch. The Asian Financial crisis was

mostly centered on the structural factors and not mainly in the interbank system. Thus, the

accumulation of excess reserves was not an option considered by thrift banks.

Global Financial Crisis

The results of the regression system analyzes that the Global Financial Crisis is

significant at t- Statistic Probability of 0.0013 which is less than α, level of significance of 0.05

and has a positive relationship with the level of excess reserves. It has been found out that the

presence of Global Financial Crisis increased the level of excess reserves by 999.6082 pesos (in

36

millions). The result is consistent with the hypothesis and to the works of Krishnamurthy (2011);

Judson et. al., (2011); Agenor et. al., (2004); Bech et. al., (2011); Cukierman (2013); Haan et al.,

(2013); and Talasli (2010).

Contrary to the effect of Asian Financial Crisis to the level of excess reserves, the Global

Financial Crisis gave more pressure to the banks to hoard more reserves. This may be explained

because thrift banks, which are relatively smaller than universal and commercial banks, is more

prone to defaults and loss on investments. Further, since universal and commercial are large

financial institutions, thrift banks prepared for unexpected spillover effect of these universal and

commercial banks to the whole financial system of the Philippines.

It can be observed that there is an increasing trend in the level of the demand deposits.

This further explains and signifies that the level of excess reserves and demand deposit are

positively related. Since there are more demand deposits, more reserves can be accumulated.

This accumulation of reserves provides a buffer against overdraft that could lead to penalty

payments to BSP. These extreme risk aversions by banks lead to liquidity lock (Hoflich, 2011).

Since reserves provided more secured interest income other than available form of

investment during a crisis, it places small banks, like thrift banks, into a less risky position. And

since thrift banks have a limited capital, their decisions should have minimal repercussions.

37

Conclusions and Recommendations

This study examined the behavior of thrift banks’ excess reserves from 1990 to 2010. It

proved that an increase in the level of demand deposits increases the level of excess reserves.

While the measurement of opportunity cost, which is the 91-day treasury bills rate, is found to be

inconsistent with the findings of the current literature. However, it is to be highlighted that the

two crises encountered by the Philippines gave a contradicting impact on the behavior of the

thrift banks’ level of excess reserves. In the Asian Financial Crisis, thrift banks did not hoard

excess reserves. On the contrary, the Global Financial Crisis pressured the financial systems

which made the thrift banks to hoard excess reserves.

Demand Deposit

Since this study found a significant relationship on how demand deposits affects excess

reserves. Monetary policy makers can use this information to optimally management the money

supply. Furthermore, since demand deposits are part of the narrow money or M1, which is the

basic money supply aside from OMO, the BSP can also regulate contractionary money supply

through accumulation of excess reserves. Since the literature suggests that uncertainty can result

to bank run, maintaining an optimal level of excess reserves can serve as cushion to sudden

shocks to demand deposits or self-fulfilling prophecy bank run of depositors. For this reason,

banks’ liquidity position must be monitored.

Since an increase in the level of demand deposit would also increase the level of excess

reserves, the study therefore suggested that whenever there is a crisis, the BSP should induce

38

willingness to deposit among the depositors to help banks maintain their liquidity and regulate

properly their level of excess reserves. Panic among banks as well as to depositors should be

minimized to avoid bank runs that lead to sudden bankruptcy of banks.

91-Day Treasury Bills Rate

Subsequently, findings on how 91-day treasury bills rate affect excess reserves can be

used on handling uncertainty, improvement of banks’ investment portfolio and assessing the

opportunity cost of holding excess reserves. Since literature supplements that there is a problem

between asset maturity and time preferences of depositors that financial institutions must face,

there is a need for banks to optimize their investment portfolio. Further, through the established

opportunity cost and benefits from holding excess reserves it can be used in weighing options

and monitor banks’ liquidity.

In addition, since 91-day treasury bills rate only affect the excess reserve on the month

after its official release, BSP should find a way in making incentive for banks to put their funds

in government securities instead of hoarding it as an excess reserves. Incentives could be by

giving a higher interest-yielding treasury bills or a more access to loans if they have efficient

government securities. By doing this suggested policy, the 91-day treasury bills rate would be

more attractive for thrift banks thus, leading them to decrease their level of excess reserves.

Crises

The difference in the effect of the two crises to excess reserves can be explained perhaps,

through the nature of the crisis itself. In the Asian Financial Crisis, the main cause of its

occurrence was the moral hazard problem. Take note that the level of excess reserves went down

during those times. It can be concluded that due to this moral hazard problem or state of being

complacent of the banks, banks had invested their funds in the global economy even though there

39

were lots of risks or losses that can be accumulated from these investments. Thus, instead of

putting their excess funds in reserves, they would rather invest it in the market even if it is risky

since the government gave them full support and bail them out if ever they have failed.

While in the Global Financial Crisis, one of the main causes of its occurrence was the

sub-prime crisis or the “housing bubble”. Take note again that the level of excess reserves went

high during this crisis. Perhaps, it could be explained that the banks were more afraid to lend out

or invest their money by this time because of so much uncertainties and risks in the global

economy. Also, since this was a global phenomenon, banks were afraid of the so-called “bank

runs”, the state wherein the people would want to withdraw their money out from the banks.

Thus, they would rather keep their funds in reserves, a much safer place, to avoid these

uncertainties, risks and banks runs.

This ironic result had given this study a much extensive view between the relationship of

crisis and excess reserves. A presence of crisis would not necessarily mean that banks would

increase their level of excess reserves. It is still depended on the nature of crisis per se. A much

effort on the part of the Bangko Sentral ng Pilipinas should be taken into importance. If the

nature of crisis would be the same as to the Asian Financial Crisis, BSP should be more

aggressive in the investment portfolios of each bank. This could be possible through policies that

would require banks to be more transparent when it comes to their investments. Aggressiveness

does not mean that the BSP should always intervene to every decision of banks but rather it is

more on the monitoring of the BSP to ensure the financial health and stability of the country.

However, if the nature of the crisis would be the same as to the Global Financial Crisis,

BSP should focus in setting the most-optimal level of interest rates or reserve requirement ratios

because these are significant to maintain the correct level of money in the economy. Take note

40

also that the crisis happened due to unpredicted financial condition which was the sub-prime

crisis or the housing bubble. The study therefore suggests that extensive research should be done

to assess the current global economy. This would help ensure the domestic financial stability of

the country and the BSP could make precautionary measures if ever there would be a future

threat in the global economy.

Other Instruments

The central bank uses various instruments to attain the inflation target set by the National

Government. The main instrument used is the regulation in the BSP’s key policy interest rates.

The central bank also employs measures to expand or contract liquidity in the financial system

through open market operations (OMO), special deposit accounts (SDA), rediscounting rates and

reserve requirement. Further, the identification of the significant effects of the endogenous

variables in the model is crucial to steering the levels of reserves to supply through OMO.

According to Goodfriend, “interest on reserves can and should be employed as a policy

instrument equal in importance with open market operations. In effect, this paper resolves the

historical dispute over bank reserves and interest rate operating procedures by pointing out how a

central bank can target both independently. Thus, a central bank without the authority to pay and

vary interest on reserves at a market rate is at a considerable disadvantage in the implementation

of monetary policy. Paying interest on reserves would seem to be expensive from the Treasury’s

point of view. Interest earnings ordinarily transferred by a central bank as tax revenue to the

Treasury would be diverted to pay interest on reserves.” In the Philippine setting, it is to be noted

that reserves have different interest rates depending on what category it is placed. This study also

suggests that since the BSP always forecast the daily level of excess reserve to be used as basis

for OMO, it would be a less burden for BSP if the individual banks will regularly provide their

41

needed level of excess reserves to optimize the procedure in determining the OMO. Further, if

this information provided by banks can be used as a basis for other there is available information

and that can be used instead of forecasting. Since excess reserves are the funds BSP use for inter-

bank borrowing, it would be optimal if there will be a regulation like ceiling or floor to optimize

the placing of banks in their excess reserves and to determine the optimal level of excess reserves

needed by those that will be in default or have deficient reserves.

42

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APPENDICES

Scatterplot:

Figure 2

The scatterplot graph between the dependent and explanatory variables is essential in determining the proper functional form used in the econometric model. The relationship of excess reserves to demand deposit, based on the scatterplot, it requires the demand deposit to be in the log form. The same applies to interest rates which takes the form of log. The Asian and Global crises were seen to be in the linear form only.

0

10,000

20,000

30,000

40,000

-4,000 -2,000 0 2,000 4,000 6,000

DEXRES

DD

EM

DE

P

0

20

40

60

80

100

-4,000 -2,000 0 2,000 4,000 6,000

DEXRES

DTB

ILLS

0

1

2

-4,000 -2,000 0 2,000 4,000 6,000

DEXRES

AS

IAN

0

1

2

-4,000 -2,000 0 2,000 4,000 6,000

DEXRES

GLO

BA

L

46

Ramsey RESET Test:

Ramsey RESET TestEquation: UNTITLEDSpecification: DEXRES C LOG(DDEMDEP) DLOG(DTBILLS) ASIAN        GLOBAL DLOG(DTBILLS(-1))Omitted Variables: Powers of fitted values from 2 to 3

Value df ProbabilityF-statistic  0.125321 (2, 242)  0.8823Likelihood ratio  0.258793  2  0.8786

Table 2

The results showed that with a specification of 2 number of fitted terms, the model passed and found to be significant at 0.1 level of significance. This verifies that the model has no misspecified variables and that the model adapts the correct functional form.

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48

Nominal Deflator Real/Deflated Dummy

OBS ExRes DemDep Tbills CPI 2000 decimal Dexres Ddemdep Dtbills Global Asian

90:Jan 83.2 594.1 19.68 42.80.309920348 268.4561 1916.944 63.50018692 0 0

90:Feb 385 620 20.31 430.311368573 1236.477 1991.209 65.22816279 0 0

90:Mar -570.8 568.4 22.93 43.20.312816799 -1824.71 1817.038 73.30168981 0 0

90:Apr -399.2 497 25.25 43.60.315713251 -1264.44 1574.213 79.97763761 0 0

90:May 305.1 649.7 22.67 43.9 0.31788559 959.7793 2043.817 71.31496583 0 0

90:Jun -170.1 650.7 23.08 44.30.320782042 -530.267 2028.48 71.94916479 0 0

90:Jul -4 670 20.93 44.9 0.32512672 -12.3029 2060.735 64.37489978 0 0

90:Aug -49.4 447.7 21.45 450.325850833 -151.603 1373.942 65.82766667 0 0

90:Sep 18.1 484.8 27.9 45.50.329471398 54.93648 1471.448 84.6810989 0 0

90:Oct 416.1 492.8 27.38 46.40.335988414 1238.436 1466.717 81.49090517 0 0

90:Nov 157.6 496.2 25.98 47.20.341781318 461.1136 1451.806 76.01351695 0 0

90:Dec -643.2 659.1 26.52 49.10.355539464 -1809.08 1853.803 74.59087576 0 0

91:Jan 96.4 481.5 28.57 50.70.367125272 262.5807 1311.541 77.82084813 0 0

91:Feb 89.2 488.2 23.96 51.70.374366401 238.2692 1304.07 64.00147002 0 0

91:Mar -278.5 501.5 23.16 52.20.377986966 -736.798 1326.765 61.27195402 0 0

91:Apr -96.9 511.9 21.94 52.50.380159305 -254.893 1346.541 57.71264762 0 0

91:May -130.8 520.2 18.85 52.90.383055757 -341.465 1358.027 49.20954631 0 0

91:Jun -56.1 536.3 17.57 53.30.385952209 -145.355 1389.55 45.52377111 0 0

91:Jul 103.1 619.6 17.26 53.90.390296886 264.1579 1587.509 44.22274583 0 0

91:Aug -26.1 620.7 20.32 54.50.394641564 -66.136 1572.82 51.48976147 0 0

91:Sep 113.8 636.5 21.96 550.398262129 285.7415 1598.194 55.13956364 0 0

91:Oct 17.5 625.5 21.56 55.10.398986242 43.86116 1567.723 54.036951 0 0

91:Nov -16.2 638.3 21.48 55.30.400434468 -40.4561 1594.019 53.64173599 0 0

91:Dec -150.1 777.4 21.1 55.60.402606807 -372.82 1930.916 52.40845324 0 0

92:Jan -29 645.6 20.19 56.20.406951484 -71.2616 1586.43 49.61279359 0 0

92:Feb -129.6 668.8 18.74 56.4 0.40839971 -317.336 1637.611 45.88641844 0 0

92:Mar -303.6 706.3 16.95 56.80.411296162 -738.154 1717.254 41.21117958 0 0

92:Apr -10.7 708.6 15.39 570.412744388 -25.924 1716.801 37.287 0 0

92:May 60.4 727.5 15.38 57.60.417089066 144.8132 1744.232 36.87461806 0 0

49

ABOUT THE AUTHORS

Felipe T. Polintan Jr. (polintan_felipejr@yahoo.com) is currently a fourth year Business Economics student in the College of Commerce and Business Administration in the University of Santo Tomas. He is a scholar of Nestlé since 2006. Moreover, he is also active in extra-curricular activities. He is the Vice President for External Affairs of UST Economics Society (UST EcoSoc), a duly recognized college-based organization of business economics department. He is also an active member of Gleeconomics, the official chorale of UST EcoSoc and UST EcoSoc Debate Team. He competed in various debate competitions such as

inter-organizational, intercollegiate and even in nationwide debate competitions i.e. annual debate competition of JPES. He also went under the internship program of the Department of Trade and Industry – Center for Industrial Competitiveness where he learned various ways on how to make the country competitive. Lastly, he is a Christian because he allows God to conquer his life and in all things that he does, he lifts it all up to Him.

Jasmin S. Poquiz (jasmin_poquiz@yahoo.com) is currently a fourth year Business Economics student in the College of Commerce Business Administration in the University of Santo Tomas. She finished her secondary education in the Polytechnic University of the Philippines –Laboratory High School. She is a member of Ecocyphers –official dance troupe of Economics Society (Ecosoc), Red Cross Youth Council and the Lakas Diwa CBA Unit. Last year, she competed in Ecosoc’s annual quiz bee entitled, EcoKNOWmics: Clash of the Wits and just recently, in the Mr. and Ms. Ideal Thomasian Economist where she placed third runner-up. Moreover, she

was part of the dean’s list in the A.Y. 2010 – 2011. Last April, she passed the civil service eligibility examination for professional level. Furthermore, she spent her summer internship in the Bangko Sentral ng Pilipinas under the Department of Research, Real and External Sector Research Group.

Justin G. Simon (justingsimon@gmail.com) is currently a fourth year Business Economics student in the University of Santo Tomas College of Commerce and Business Administration. He is the Vice President for Finance of the Junior Philippine Economics Society, the junior arm of Philippine Economics Society and a duly recognized national society for all economics students of the Philippines. Moreover, he is also the vice-captain of the UST Economics Society Debate Team and an active member of the Commerce Pautakan Team, the official team of the college for the annual intercollegiate quiz bee, and the Commerce Social Science

Team, another official team of the college for the an annual intercollegiate quiz bee. He competed in various debate competitions such as inter-organizational, intercollegiate and nationwide debate competitions, such as the annual debate competition of JPES. He also went under the internship program of the Bureau of Customs where he worked under the Planning and Policy Research Division and International Affairs and learned how the country would benefit domestically and internationally from effective customs policies.

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