Reserve rate cut a stealth capital injection

Starting September 1, the Central Bank of Iraq (CBI) has announced it will be reducing the required reserve rate (RRR) from 20% to 15%. As this move frees up an additional 5% of deposits for the banks to lend out, you might think it would be positive for loan growth and stimulative for the economy as a whole. In fact, however, from a macro point of view it is likely to be a non-event.

At the moment, the required reserve ratio simply isn’t a binding constraint on bank lending. As of the end of March (the last reported month for this data), the system-wide excess reserves to deposits ratio came to 57%. (See chart. Data is from the CBI Unless this percentage has fallen dramatically since then, the banks are sitting on more cash than they know what to do with, which means that the only effect of the RRR cut will be to reclassify a portion of their reserves from ‘required’ to ‘excess’.

This reclassification itself, however, is positive for bank earnings because excess reserves earn interest at a rate of 4% (2 percentage points below the CBI policy rate) while required reserves are unremunerated. From the point of view of the banks, it’s as if their loan books grew overnight by an amount equal to 5% of (reservable) deposits, with a spread of 4 percentage points on the new loans. (The spread is the difference between a bank’s deposit and lending rates. As the “new loans” in this case increase interest revenue without increasing interest expense, it's as if they were funded with non-interest-bearing deposits.)

The RRR cut is thus neutral for the economy—it won’t lead to an increase in lending—but a plus for the banks, who are effectively getting a stealth capital injection from the CBI.

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