Minimum Reserve Requirements
We refer to the document entitled "Minimum Reserve Requirements", submitted to the Portfolio Committee on Finance under cover of a letter from the South African Reserve Bank to Mr A Hermans, ("the Report") and to your request for comment from the Banking Industry.
The Report aims to motivate the proposed amendment to section 10A(2) of the South African Reserve Bank Act ("the Act") which will vest in the Governor of the Reserve Bank a discretion to specify from time to time what percentage of commercial banks' note and coin holdings may be counted as part of their prerequisite minimum reserve balances. Currently all (100 per cent.) of note and coin holdings are taken into account. This means that the amount which banks are required to hold on deposit with the Reserve Bank (2.5% of adjusted liabilities) is decreased by the amount of cash they hold in their vaults.

If in future the Governor exercises his discretion and specifies, for example, that only 50% of bank's cash holdings may be taken into account, the amount which banks are required to hold on deposit with the Reserve Bank will increase by the same amount. In other words, banks will, in this example, be required to deposit an additional R4.4 billion (approximately) with the Reserve Bank.
Because of the potentially serious repercussions of such a move, it is important that the exercise of such a discretion is properly managed, and the detrimental consequences to banks are mitigated by way of adequate compensation.

The reason for the proposed amendment (not expressly stated in the Report, but communicated to the banks by SARB) is to increase the "reserve dependency" of commercial banks. Reserve dependency is the amount of funding for which commercial banks rely on the Reserve Bank. Because of this dependency, the Reserve Bank can influence the interest rates charged by banks (by varying the rate at which the Reserve Bank lends to commercial banks the funds they require to make up their shortage). This is accepted by the banks as a good thing, as it gives the Reserve Bank the ability to play a stabilising role in the economy, and to positively aid the economic development of the country. The banking industry thus supports the Reserve Bank in this objective, and will for this reason also support the passage of the proposed amendment to section 10A of the Act.

The banks remain concerned about the adverse consequences which might flow from an exercising of the discretion. The Reserve Bank has since the time of its initial briefing to the Portfolio Committee, given the Banking Council a positive undertaking that these concerns will be addressed before the discretion is exercised, and the banks are confident of a favourable resolution.
It is nonetheless an important aspect of democaratic governance that the legislature carefully considers the consequences which might flow from the exercising of any of the discretions which Parliament might from time to time be asked to confer.
In our view, the potential consequence of the amendment are not fully dealt with in the Report, and it is on this aspect that we wish to focus this response.

The cost of reserve balances
Banks raise deposits from the public and pay interest on these balances. They make money by using these deposits to make loans to other people (borrowers) at a higher rate. The difference between the rate of interest a bank pays on deposits and that which it charges for loans (less the cost of these transactions) is its profit.

The Reserve Bank does not currently pay interest on the balances deposited by banks, although it may do so and has done so in the past.

Also, because the Reserve Bank requires a bank to deposit this money with it, that bank is left short of funds, and it can buy that money back from the Reserve Bank by selling some of its other assets to the Reserve Bank through the repo system. For the funds provided by the Reserve Bank, the bank pays interest at the prevailing repo rate (currently about 13%).

The interest forgone on minimum reserves and cash holdings constitutes a loss for commercial banks. On the basis of 1999 figures, this amounts to a loss of about R 1.6 billion to the 4 major banks alone.

If the proposed discretion were used to its fullest extent without compensation, these banks would lose an additional R 1.1 billion per annum.

International trends
As mentioned in the Report (last sentence, page 1), there is a general tendency internationally towards lowering or abolishing reserve ratios.

The reason for this is best stated in the words of Mr Fienman of the USA Federal Reserve Board:
" Requiring depositories to hold idle, non-interest-bearing balances is essentially like taxing these institutions in an amount equal to the interest they could have earned on these balances in the absence of reserve requirements. This forgone interest, or reserve "tax", directly affects only the depository system and its customers, and not other parts of the financial system. Hence, it creates an artificial incentive for depositors and borrowers to bypass the depository system, and in so doing it may redirect credit flows in ways that impair the efficiency of resource allocation." (Joshua N. Feinman, Federal Reserve Board, Monetary Affairs Division, Reserve Requirements: History, Current Practice, and Potential Reform. 1993 Federal Reserve Bulletin.)

In other words, the cost to a bank of placing deposits at zero interest is spread out over its entire deposit base (which means that it pays approximately 32 basis points less than it would have) thereby reducing the competitiveness of the banking industry, and placing the other sectors (eg. insurance companies) competing for the nation's savings in an unfair advantage.
By exercising the discretion conferred by this amendment, the Governor of the Reserve Bank will increase the effective rate at which minimum reserves are maintained.

The Report contains a comprehensive comparison between the minimum reserve requirement imposed in South Africa and in other countries (refer pages 6, 9 and 10 of the Report).
On the face of it, South Africa is not too far out of line, but it is wrong to assume that equal percentages mean that the cost of reserve balances are the same for banks in all countries. Interest is in part a fee (compensation) for the use of someone else's money, but is quite significantly also a compensation for the diminishing value of the currency of the loan. (This explains in part why interest rates in South Africa are higher than interest rates in the developed economies.) Thus the cost to South African banks of depositing money at zero interest is higher than the equivalent cost to American banks (for example). An American bank depositing at zero interest (where the interest forgone is about 5%) loses only the compensation it would have received for the use of the money (since its currency does not diminish in value). South African banks depositing at zero interest (where interest forgone is about 13%) loses the compensation it could have received for the use of the money (about 5%) but also an additional 8% due to the diminishing value of the currency.

Why are banks permitted to count vault cash (note and coin) as part of their minimum reserves?
The issuing of note and coin is the sole purview of the Reserve Bank, according to section 14 of the Act. It is the duty of the Reserve Bank to manufacture and distribute legal tender, required in general commerce as a unit of exchange.
Currently, this responsibility is undertaken by commercial banks which use their branch and ATM networks to distribute cash on the South African Reserve Bank's behalf.
By subtracting the cash that they hold from the required reserve balance, banks are compensated for this function.

Will all banks be effected equally by this amendment?
Not all banks are the same. There are banks which do not deal with the general public, but specialise in merchant and investment banking. Other banks (generally referred to as "niche banks") provide services to a very limited segment of the market. These banks do not hold significant amounts of cash.

Retail banks (or "full service banks") provide services to the general public. These banks hold significant amounts of cash which they distribute on behalf of the Reserve Bank. It is these banks which will be adversely affected if the Governor exercises his discretion under the amended section 10A(2) of the Act without compensating these banks in some other way.

Currently, retail banks are already under pressure due to (i) the high cost of maintaining branch networks, and (ii) the high crime rate and expense of moving and securing cash. Between 1994 and 1998, 441 bank branches were closed down.

The Reserve Bank will not be able to use the discretion conferred by the amendment to reapportion liquidity between big banks and small banks. Small banks which hold a significant amount of cash will be as badly affected as big banks.

Since the affect of exercising the discretion would be punitive, it will in our view be unconstitutional for the Reserve Bank to specify different percentages for different banks.

Absorbing the cost
If retail banks were to absorb the additional R 1.2 billion cost which would arise if the discretion were exercised to its fullest extent, it would impact negatively on their respective ROE's. (ROE, or return on equity, is the profit which shareholders earn on the money they invest in a company.)
In order to attract investors, banks must earn a higher return than the investor could earn on a risk free investment in government bonds. This is because the money invested in a bank is placed at risk, and in order to put his/her money at risk the investor has to be offered a higher reward.
Contrary to general perception, South African banks are not highly profitable. The table below is based on 1998 data.

ROE's around the world

Source: KPMG International Banking Surveys
The figures in the last column demonstrate that there is little scope for South African retail banks to lower their profits.

Recovering the cost
The alternative when additional costs are incurred is to recover them from the banking public. Because of the advent of niche banks (as discussed above), which compete with full service banks in specific market sectors, costs are recovered directly from the customers who use that service in respect of which the cost is incurred. This means that if the cost of holding and distributing cash increases, the users of cash will be charged extra for that service. As demonstrated below, this will affect mainly the lower income and rural communities.

Additional costs create disincentives for banks to service the cash-intensive low income market. If higher costs result in customers no longer using the services, the bank will contract those services. In this case banks may be forced to close rural and marginal branches.

Global competition
Because of the mobility of capital and financial assets in the global economy, banks in South Africa are in direct competition with banks in other countries. Any cost imposed on a South African Bank which is not also imposed in banks in other countries, put South African banks at a competitive disadvantage. Banks in the UK (which does not impose a minimum reserve balance) are thus at an advantage over South African banks in tendering for any banking business.

Compensation
None of the adverse consequences demonstrated above would result if the retail banks which stand to lose the advantage of their vault cash deduction, were to be compensated in some other way.
There are two components to the cash distribution function which commercial banks perform on behalf of the Reserve Bank: (i) the holding of cash and (ii) the delivery of the cash.
The cost of holding cash is the interest which the bank could have earned had it invested that cash in an income producing asset (government bonds, for example). The cost of delivering the cash is the cost associated with security, branches and ATM networks.
If no compensation were offered for holding the cash and compensation were only paid for moving (delivering) the cash, banks would minimise their losses by holding as little cash as possible, and would return all excess cash to the Reserve Bank on a daily basis. This would significantly increase the amount of "cash in transit" and would create additional costs and additional opportunities for crime.
The Retail Banks are thus in favour of a basis of compensation based on the cash holding, which would minimise their need to move cash to and from Reserve Bank branches.

It should be noted, that the views expressed in this paragraph on compensation are those of the major retail banks and are not shared by the whole banking industry.

Conclusion
The Banking Industry is grateful for the willingness of the Reserve Bank to address these issues.