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Liquidity preferences of commercial banks : the Canadian case Brown, Lawrence David 1969

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LIQUIDITY PREFERENCES OF COMMERCIAL BANKS: THE CANADIAN CASE by LAWRENCE DAVID BROWN A . , U n i v e r s i t y of B r i t i s h Co lumbia , 1967 A THESIS SUBMITTED IN PARTIAL ' FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF ARTS ; i n the Department o f Economics We accept t h i s t h e s i s as conforming to the r e q u i r e d s t a n d a r d THE UNIVERSITY OF BRITISH COLUMBIA Augus t , 1969 In p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t o f the r e q u i r e m e n t s f o r an advanced deg ree a t the U n i v e r s i t y o f B r i t i s h C o l u m b i a , I a g r e e t h a t t he L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e and S t udy . I f u r t h e r a g r e e t h a t p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y pu rpo se s may be g r a n t e d by the Head o f my Department o r by h i s r e p r e s e n t a t i v e s . It i s u n d e r s t o o d t h a t c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l no t be a l l o w e d w i t h o u t my w r i t t e n p e r m i s s i o n . Department o f The U n i v e r s i t y o f B r i t i s h Co lumb ia Vancouve r 8, Canada ABSTRACT I n c o n j u n c t i o n w i t h the r e c e n t i n t e r e s t i n the l i q u i d i t y p r e f e r e n c e s o f c o m m e r c i a l b a n k s , w h i c h i s i t s e l f p a r t o f a new s u p p l y t h e o r y o f money, t h i s t h e s i s i n v e s t i -gates t h e r e s e r v e b e h a v i o u r o f C a n a d i a n c o m m e r c i a l banks from 1920-1939 . ' S e v e r a l models o f bank r e s e r v e b e h a v i o u r are p r e s e n t e d i n c l u d i n g the one t o be t e s t e d i n t h i s t h e s i s . T h i s model d i f f e r s f rom t h e o t h e r s i n t h a t i t w i l l be t e s t e d w i t h m o n t h l y d a t a on i n d i v i d u a l banks (and hence can e x p l a i n d i f f e r e n c e s among banks as t o the h o l d i n g o f r e s e r v e s ) whereas t h e o t h e r s were t e s t e d w i t h a n n u a l d a t a f o r a group o f banks or a b a n k i n g s y s t e m . S i n c e t h e r e was no r e q u i r e d r e s e r v e i n Canada p r i o r t o M a r c h , 1935 , t h e r e was a l s o no d e f i n i t i o n o f what c o n s t i t u t e d r e s e r v e s . T h i s p r o b l e m had t o be i n v e s t i g a t e d b e f o r e any. r e s e r v e r a t i o s c o u l d be c a l c u l a t e d . , A f t e r c a l c u l a t i n g some r e s e r v e r a t i o s , s e v e r a l i n t e r e s t i n g o b s e r v a t i o n s can be made. The h y p o t h e s i s t h a t Canad ian , c o m m e r c i a l banks adhered t o a t e n p e r c e n t r e q u i r e d r e s e r v e r a t i o t h r o u g h a g e n t l e m e n ' s agreement w i t h i n the C a n a d i a n Banker s A s s o c i a t i o n was c l e a r l y r e f u t e d . A l s o the i i i e f f e c t of t h e e s t a b l i s h m e n t o f the .Bank of Canada on r e s e r v e h o l d i n g s was / / n o t i c e d . . F u r t h e r m o r e , the e v i -dence c a s t some doubt on the c o n c l u s i o n s o f George M o r r i s o n i n h i s b o o k , L i q u i d i t y P r e f e r e n c e s o f Commerc i a l B a n k s . The model p r e s e n t e d p r e v i o u s l y was t h e n t e s t e d b o t h w i t h m o n t h l y d a t a f o r i n d i v i d u a l banks and w i t h m o n t h l y d a t a f o r the b a n k i n g sys tem as a w h o l e . The t e s t s u s i n g m o n t h l y d a t a f o r t h e i n d i v i d u a l banks i n d i -c a t e d the need f o r f u r t h e r r e f i n e m e n t o f the model a l t h o u g h c o n s i d e r i n g the number o f o b s e r v a t i o n s and 2 the d i v e r s i t y among banks perhaps t h e R was n o t t h a t b a d . . The R was much i m p r o v e d when m o n t h l y d a t a f o r t h e b a n k i n g sys tem was u s e d . T h i s i s t o be e x p e c t e d as a g g r e g a t i o n s o v e r banks h i d e s much d e t a i l w h i c h , t h u s , does n o t have t o be e x p l a i n e d . i v TABLE OF CONTENTS Page A b s t r a c t . . . . . . . . . . . . . . . . . . . . . i i L i s t o f T a b l e s . . . . . . . . . . . . . . . . . . v L i s t o f I l l u s t r a t i o n s . . . . . . . . . . . . . . v i A c k n o w l e d g e m e n t s . . . . . . . . . . . . . . . . . v i i i C h a p t e r I L i q u i d i t y P r e f e r e n c e s o f Commerc ia l B a n k s : The C a n a d i a n Case . . . . . 1 I I . A Model o f Bank R e s e r v e B e h a v i o u r . . . 13 I I I The Concept and Measurement o f Reserve R a t i o s . . . . . . . . . . . . . 31 IV The Reserve R a t i o s : O b s e r v a t i o n s and C o n c l u s i o n s . . . . . . . . . . 43 V The T e s t i n g o f t h e M o d e l . . . 52 VI C o n c l u s i o n s . . . . . . . . . . . . . . 61 A p p e n d i x . . . . . . . . . . . . . . . . . . . . . 63 B i b l i o g r a p h y . . . . . . . . . . . . . . . . . . . 84 V LIST OF TABLES TABLE PAGE I P o s s i b l e i t e m s t o be i n c l u d e d i n the c a l c u l a t i o n o f the r e s e r v e r a t i o s . . . . . . . . • , 3 7 I I Mean o f the Cash R a t i o (E.) f o r each b a n k . . . . • . • 47 I I I R e g r e s s i o n s on I n d i v i d u a l Bank d a t a 55 IV R e g r e s s i o n s on C a n a d i a n B a n k i n g System d a t a . 59 v i L I S T OF I L L U S T R A T I O N S FIGURE PAGE 1 R a t i o s A and E f o r t h e C a n a d i a n B a n k i n g S y s t e m . 64 2 R a t i o s A , B , D , and E f o r t h e Bank o f M o n t r e a l . . . . . . . . . . . . . . 65 3 R a t i o s A and E f o r t h e Bank o f N o v a S c o t i a . . 66 4 R a t i o s A , . B , D and E f o r M o l . s o n ' s Bank . . . . . . . . . . 67 5 R a t i o s A and E f o r t h e Bank o f T o r o n t o . . 68 6 R a t i o s A and E f o r t h e Banque P r o v -i n c i a l e Du C a n a d a . . 69 7 R a t i o s A and E f o r t h e M e r c h a n t s Bank o f C a n a d a - 7 0 8 R a t i o s A and E f o r t h e U n i o n Bank o f C an ad a . . . . • . . . . . 71 9 R a t i o s A and E f o r t h e Banque N a t i b n a l e . . . . . . v . 72 10 R a t i o s A and E f o r t h e C a n a d i a n Bank o f Commerce • 7 3 11 R a t i o s A a n d . E f o r t h e R o y a l Bank o f C a n a d a . 74 12 R a t i o s A and E f o r t h e D o m i n i o n Bank 75 13 R a t i o s A and E f o r t h e Banque C a n a d i e n n e N a t i o n a l e . . . . . . . . . 76 v i i FIGURE PAGE 14 R a t i o s A and E f o r the Bank ... -o f H a m i l t o n . . . . . . . . . . . . . . 77 15 R a t i o s A and E f o r the- S t a n d a r d Bank o f Canada . . . . . . . . . . . . . 78 16 R a t i o s A and E f o r the I m p e r i a l Bank of Canada.- . . . . . . . . . . . . 79 17 • R a t i o s A and E f o r the Home Bank o f Canada . . . . . . . 80 18 R a t i o s A and E f o r the S t e r l i n g Bank o f C a n a d a . . . . . . . . . . . . . 81 19 R a t i o s A and E f o r t h e Weyburn S e c u r i t y Bank . . . . . . . . . . . . . 82 20 R a t i o s A and E f o r B a r c l a y ' s Bank o f C a n a d a . . . . . . . . . . . . . 83 . v i i i ACKNOWLEDGEMENTS I w o u l d l i k e to thank D r . R o n a l d A . S h e a r e r f o r the t i m e he s p e n t r e a d i n g and commenting on the many d r a f t s o f t h i s t h e s i s , and f o r h i s v e r y e n l i g h t e n i n g comments. I w i s h t o e x p r e s s my thanks a l s o t o t h e - s t a f f o f the S t a t i s t i c a l C e n t r e a t U . B ' . G . f o r t h e i r i n v a l u a b l e a i d i n c a r r y i n g o u t ' t h e g r e a t amount o f computer w o r k . F i n a l l y , I w i s h t o thank my w i f e , I r e n e , f o r the i n n u m e r a b l e ways i n w h i c h she c o n t r i b u t e d t o t h i s t h e s i s , t h r o u g h c o n s t a n t encouragement and e x c e l l e n t t y p i n g . CHAPTER ONE L I Q U I D I T Y PREFERENCES OF COMMERCIAL BANKS: THE CANADIAN CASE I n t r o due t i o n In h i s r e c e n t b o o k , L i q u i d i t y P r e f e r e n c e s o f  C o m m e r c i a l B a n k s , \ G e o r g e M o r r i s o n i n v e s t i g a t e s t h e r e -s e r v e b e h a v i o u r o f c o m m e r c i a l b a n k s , and a f t e r l o o k i n g a t t h e C a n a d i a n b a n k i n g s y s t e m , he c o n c l u d e s t h a t i t h e l d l i t t l e o r no e x c e s s r e s e r v e s . In t h i s t h e s i s I w i l l examine h i s f i n d i n g more f u l l y and on an i n d i v i d u a l bank b a s i s i n o r d e r t o i s o l a t e t h e d e t e r m i n a n t s o f the- r e s e r v e h o l d i n g s o f i n d i v i d u a l C a n a d i a n c o m m e r c i a l b a n k s . Why t h i s i n t e r e s t i n t h e r e s e r v e b e h a v i o u r o f c o m m e r c i a l b a n k s ? T h i s i s an i m p o r t a n t p a r t o f a new s u p p l y t h e o r y o f money t h a t i s . e m e r g i n g . M u l t i p l i e r A n a l y s i s F o r many y e a r s , t h e t h e o r y o f t h e s u p p l y o f money was l a r g e l y t h e t h e o r y o f t h e m u l t i p l i e r * T h i s m u l t i p l i e r G e o r g e M o r r i s o n , L i q u i d i t y P r e f e r e n c e s o f C o m m e r c i a l B a n k s , The U n i v e r s i t y o f C h i c a g o P r e s s , C h i c a g o , I l l i n o i s , 1 9 6 6 . 2 ( the i n v e r s e o f the r e q u i r e d r e s e r v e r a t i o ) t i m e s any change i n bank r e s e r v e s gave the change i n the t o t a l money s u p p l y . G r a d u a l l y the m u l t i p l i e r became more s o p h i s t i c a t e d as c e r t a i n e c o n o m i s t s took a c c o u n t o f one o r a l l o f the f o l l o w i n g : d i f f e r i n g r e s e r v e r a t i o s between demand and t ime d e p o s i t s , the r a t i o o f c u r r e n c y t o the t o t a l money s u p p l y t h a t p e o p l e want t o h o l d , the demand f o r c u r r e n c y by f i n a n c i a l i n t e r m e d i a r i e s and the h o l d i n g o f exces s r e -s e r v e s by t h e b a n k s . An e a r l y s t u d y o f 'this t ype i s Dona ld 2 S h e l b y ' s i n v e s t i g a t i o n o f the monetary i m p l i c a t i o n s o f the g rowth o f f i n a n c i a l i n t e r m e d i a r i e s . In a n o t h e r s t u d y , S . L . 3 M a c d o n a l d , l o o k s a t the c u r r e n c y r a t i o and s t a t e s c e r t a i n causes o f changes i n i t , such as i n c r e a s e d u r b a n i z a t i o n and i m p r o v e d t r a n s p o r t a t i o n . One r e q u i r e m e n t o f the m u l t i p l i e r a n a l y s i s i s t h a t the r a t i o s m e n t i o n e d be f a i r l y c o n s t a n t o v e r t i m e . I f they change o f t e n , t h e n the m u l t i p l i e r a n a l y s i s w i l l be o f l i t t l e use s i n c e any p r e d i c t i o n made by c a l c u l a t i n g v a l u e s f o r the r a t i o s at a c e r t a i n t i m e may not be even c l o s e to the a c t u a l r e s u l t i f the r a t i o s have changed i n t h e meant ime . There i s D o n a l d S h e l b y , "Some I m p l i c a t i o n s o f the Growth o f F i n a n -c i a l I n t e r m e d i a r i e s , " J o u r n a l o f F i n a n c e , V o l . 1 3 : 5 2 7 - 4 1 , ( D e c . 1 9 5 8 ) . S . L . M a c d o n a l d , "The I n t e r n a l D r a i n and Bank C r e d i t E x -p a n s i o n , " J q ^ u r n a ^ 407-21 (Dec . 1 9 5 3 ) . 3 ' some e v i d e n c e t h a t the r a t i o s are n o t i n d e e d c o n s t a n t . J . A h e n s d o r f and S, K a n e s a t h a s a n c o n c l u d e t h a t much r e s e a r c h i s n e c e s s a r y t o e x p l a i n v a r i a t i o n s i n the c u r r e n c y / m o n e y r a t i o , t h e exce s s r e s e r v e r a t i o , and t h e r a t i o o f demand t o t ime d e p o s i t s . New S u p p l y Theory o f Money I f t h e n we cannot assume t h a t t h e r a t i o s are c o n s t a n t , i t i s n e c e s s a r y t o i n v e s t i g a t e them as b e h a v i o u r a l r e l a t i o n - .:• s h i p s i n o r d e r t o f i n d out t h e d e t e r m i n a n t s o f changes i n the r a t i o s b e f o r e we can p r e d i c t w i t h any c e r t a i n t y what a f f e c t a change i n bank r e s e r v e s w i l l have on the money s u p p l y . T h u s , r a t h e r t h a n u s i n g the m u l t i p l i e r a n a l y s i s , e c o n o m i s t s have begun t o f o r m u l a t e a s u p p l y t h e o r y o f money on o t h e r b a s e s . One o f the f i r s t moves i n t h i s d i r e c t i o n i s the s t u d y by A . H . M e l t z e r * ' w h i c h r a t h e r t h a n u s i n g c o n s t a n t r a t i o s uses d e f i n -i t i o n s and e q u a t i o n s f o r t h e i n s t i t u t i o n a l r e s t r a i n t s and a s s u m p t i o n s about the b e h a v i o u r o f the banks and the p u b l i c . K a r l B r u n n e r and A . H . M e l t z e r , ^ i n a s u r v e y a r t i c l e , s t a t e J . A h e n s d o r f and S. K a n e s a t h a s a n , " V a r i a t i o n s i n the Money M u l t i p l i e r and T h e i r I m p l i c a t i o n s f o r C e n t r a l B a n k i n g " , I . M . F . S t a f f . P a p e r s , V o l . 8 : . 126 - 4 5 (Nov . 1 9 6 0 ) . A . H . M e l t z e r , "The. F r e n c h Money S u p p l y , " J o u r n a l o f P o l i t i c a l Economy, V o l . 6 7 , N o . 3 : 275- 91 (jJune, 1 9 5 9 ) . K a r l B r u n n e r and A . H ; M e l t z e r , "Some F u r t h e r I n v e s t i g a t i o n s o f Demand and S u p p l y F u n c t i o n s f o r M o n e y " , J o u r n a l o f  F i n a n c e , V o l . 19 : 240-83 (May, 1 9 6 4 ) . 4 t h a t t h r e e d i s t i n c t money s u p p l y t h e o r i e s are e m e r g i n g . One t h e o r y , a c t u a l l y more a group o f t h e o r i e s , c e n t e r s on the b a n k s 1 r e sponse t o f r e e r e s e r v e s . A n o t h e r t h e o r y 8 c e n t e r s on the b a n k s ' r e s p o n s e to s u r p l u s r e s e r v e s . A t h i r d t h e o r y i s ba sed on some homogene i ty p r o p e r t i e s o f demand b e h a v i o u r and c e n t e r s on a mutua l a d j u s t m e n t o f a c t u a l and d e s i r e d a l l o c a t i o n r a t i o s . 9 A l o n g w i t h t h i s deve lopment o f a t h e o r y o f the s u p p l y c u r v e f o r money, t h e r e have been i n v e s t i g a t i o n s o f the p r o p e r t i e s o f t h i s s u p p l y c u r v e . R . L . T e i g e n ^ f i n d s t h a t the money s u p p l y i s e l a s t i c w i t h r e s p e c t t o i n t e r e s . t r a t e s and t h a t t h i s e l a s t i c i t y i s due m a i n l y t o the r e s p o n s e o f member bank b o r r o w i n g t o i n t e r e s t r a t e and d i s c o u n t r a t e c h a n g e s . O t h e r e c o n o m i s t s have c o n c e n t r a t e d on a c e r t a i n a s p e c t o f a new s u p p l y t h e o r y o f money. An example i s the A . James M e i g s , Free Rese rve s and the Money S u p p l y , The U n i v e r s i t y o f C h i c a g o P r e s s , C h i c a g o , I l l i n o i s , 1962 . K a r l B r u n n e r , " A Schema f o r the S u p p l y Theory o f M o n e y " , I n t e r n a t i o n a l Economic R e v i e w , V o l . 2 , N o . 1: 79-109 , ( J a n . 1 9 6 1 ) . K a r l B r u n n e r , " A Case S tudy o f l ) , S , M o n e t a r y P o l i c y : The I n f l a t i o n a r y G o l d F lows o f the M i d d l e T h i r t i e s , " S c h w c i z e r i s c h e K c i t s c h r i f t f u e r V o l k s w i r t s c h a f t und S t a t i s t i k , 1958 . - R . L . T e i g e n , "The Demand f o r and S u p p l y o f M o n e y " , Read ings i n N a t i o n a l Income and S t a b i l i z a t i o n P o l i c y , R i c h a f d D. I r w i n , I n c . , Homewood, I l l i n o i s , 1 9 6 5 , : 4 4 - 7 6 . s y s t e m a t i c i n v e s t i g a t i o n o f the c u r r e n c y r a t i o by P . C a g a n 1 1 i n w h i c h he f i n d s that , two v a r i a b l e s , e x p e c t e d net r a t e o f i n t e r e s t p a i d on d e p o s i t s ,and e x p e c t e d r e a l income p e r c a p i t a have been ma jor d e t e r m i n a n t s o f the c u r r e n c y r a t i o . I n t e r e s t has a l s o been shown i n the p a r t t h a t non-bank f i n a n c i a l i n t e r -m e d i a r i e s p l a y i n the money s u p p l y p r o c e s s . Perhaps the g r e a t e s t i n t e r e s t , : h o w e v e r , has been i n the a c t i o n s o f the • banks t h e m s e l v e s and how t h e s e a c t i o n s d e t e r m i n e among o t h e r : t h i n g s the h o l d i n g o f r e s e r v e s . Reserve B e h a v i o u r o f Banks 12 F . B r e c h l i n g and G . C l a y t o n . c o n s t r u c t a s i m p l e t h e o r y o f bank p o r t f o l i o b e h a v i o u r w i t h t h e r a t e o f i n t e r e s t , l e v e l o f economic a c t i v i t y , f i r s t d i f f e r e n c e s o f the r a t e o f i n t e r e s t and the l e v e l o f e x o g e n o u s l y d e t e r m i n e d l i q u i d a s s e t s as d e t e r -13 m i n a n t s o f the d e s i r e d a s s e t r a t i o s . D . O r r and W . G . M e l l o n b r i n g u n c e r t a i n t y , as to w i t h d r a w a l s ' from-/and a d d i t i o n s t o , i t s r e s e r v e s and cash b a l a n c e s , i n t o the d e c i s i o n making o f a b a n k . W i t h r e g a r d s t o the b a n k i n g sys tem as a w h o l e , t h e y f i n d t h a t 1 1 P h i l l i p Cagan , '.'The Demand f o r C u r r e n c y R e l a t i v e t o the T o t a l M o n e y - S u p p l y " , J o u r n a l o f P o l i t i c a l Economy, V o l . 6 6 , N o . 4 , 3 0 3 - 2 8 , ; ( A u g u s t , 1958) . 1 2 F . B r e c h l i n g and G. C l a y t o n , " C o m m e r c i a l Banks' P o r t f o l i o B e h a v i o u r " , Economic J o u r n a l , V o l . 7 5 , N o . 298 : 290-316 ( J u n e , 1 9 6 4 ) . 1 3 D . O r r a n d " W . G . M e l l o n , " S t o c h a s t i c Rese rve Los se s and E x p a n s i o n o f Bank C r e d i t , " A m e r i c a n Economic Review;, V o l . . 5 1 , N o . 4 : 614-23 ( S e p t . 1 9 6 1 ) . u n c e r t a i n t y w i l l i n c r e a s e w i t h , the number o f banks i n the s y s t e m , and t h u s , as we i n c r e a s e the number o f b a n k s , we a l s o i n c r e a s e the h o l d i n g o f exces s r e s e r v e s a g a i n s t the i n c r e a s i n g u n c e r t a i n t y . T h u s , the r e s e r v e r a t i o r a t h e r than b e i n g c o n s t a n t w i l l be a f u n c t i o n o f u n c e r t a i n t y . R . C . P o r t e r ^ a l s o i n c o r p o r a t e s u n c e r t a i n t y i n the p o r t f o l i o s e l e c t i o n o f b a n k s , b u t i n t h i s case u n c e r t a i n t y about f u t u r e d e p o s i t l e v e l s , about market v a l u e s o f s e c u r i t i e s , about l o a n de-f a u l t s and about the banks a b i l i t y t o a c h i e v e the p o r t f o l i o i t w a n t s . S . M . G o l d f e l d , ^ a g a i n u s i n g u n c e r t a i n t y , s p e c i f i e s and e s t i m a t e s e q u a t i o n s e x p l a i n i n g changes i n banks h o l d i n g s o f exces s r e s e r v e s . He uses v a r i a b l e s such as the T r e a s u r y B i l l r a t e , s e a s o n a l dummy v a r i a b l e s , changes i n demand and t i m e d e p o s i t s , change i n t h e i r h o l d i n g s o f l o a n s and changes 16 i n p o t e n t i a l d e p o s i t s . J . T o b i n , l o o k i n g n o t at exces s r e s e r v e s , bu t at f r e e r e s e r v e s ( exces s r e s e r v e s minus b o r r o w e d r e s e r v e s ) , s t a t e s t h a t f r e e r e s e r v e s w i l l be i n -f l u e n c e d by the d i s c o u n t r a t e , the banks' cash p r e f e r e n c e s 1 4 R . C . P o r t e r , " A Model o f Bank P o r t f o l i o S e l e c t i o n " , Y a l e Economic E s s a y s , V o l . 1., N o . 2 : 322-59 ( F a l l , 1 9 6 1 ) . 1 5 S . M . G o l d f e l d , C o m m e r c i a l Bank B e h a v i o u r and Economic A c t i v i t y , N o r t h - H o l l a n d P u b l i s h i n g Company, Amsterdam, 1966 . 1 6 J . T o b i n , " C o m m e r c i a l Banks as C r e a t o r s o f M o n e y " , i n B a n k i n g and M o n e t a r y S t u d i e s , e d . , by Deane C a r s o n , F o r t h e C o m p t r o l l e r o f the C u r r e n c y , U . S . T r e a s u r y , R i c h a r d D. I r w i n , 1963 . 7 and e x p e c t a t i o n s o f f u t u r e economic m a g n i t u d e s and v a r i o u s money m a r k e t r a t e s . As m e n t i o n e d a t t h e b e g i n n i n g 17 o f t h i s p a p e r , George M o r r i s o n a l s o l o o k e d a t t h e r e s e r v e h o l d i n g s o f c o m m e r c i a l b a n k s . F o r A m e r i c a n b a n k s , he f i n d s t h a t t h e y h e l d e x c e s s r e s e r v e s ( u n l i k e h i s f i n d i n g s f o r C a n a d i a n banks ) and he s e t up a m o d e l o f bank b e h a v i o u r w i t h t h e d e s i r e d c a s h r a t i o as a f u n c t i o n o f t h e y i e l d on s e c o n d a r y r e s e r y e a s s e t s , t h e F e d e r a l R e s e r v e d i s c o u n t r a t e , t h e s p r e a d b e t w e e n y i e l d s on bonds o f d i f f e r e n t g r a d e and t r a n s i t o r y d e p o s i t p o t e n t i a l (a measure o f u n c e r t a i n t y as t o d e p o s i t 18 w i t h d r a w a l s ) . W. P o o l e u s i n g an a n a l y s i s s i m i l a r t o M o r r i s o n ' s e x p l o r e s more f u l l y t h e t h e o r e t i c a l i m p l i c a t i o n s o f t h e m o d e l . M o r r i s o n ' s R e s u l t s and t h e Ten P e r C e n t R e s e r v e R a t i o Because o f t h i s c u r r e n t i n t e r e s t i n a new s u p p l y t h e o r y o f money and i n p a r t i c u l a r , t h e p a r t d e a l i n g w i t h t h e banks demand f o r r e s e r v e s , i n t h i s t h e s i s I w i l l i n v e s t i g a t e t h e demand f u n c t i o n f o r r e s e r v e s o f t h e i n d i v i d u a l C a n a d i a n c o m m e r c i a l b a n k s . As a l r e a d y s t a t e d , M o r r i s o n i n h i s s t u d y f o u n d t h a t t h e C a n a d i a n b a n k i n g s y s t e m h e l d l i t t l e o r no e x c e s s r e s e r v e s . H i s method o f c a l c u l a t i o n was t o s u b t r a c t 17 George M o r r i s o n , L i q u i d i t y P r e f e r e n c e s o f C o m m e r c i a l B a n k s , U n i v e r s i t y o f C h i c a g o P r e s s , C h i c a g o , I l l i n o i s , 1966. 18 W. P o o l e , " C o m m e r c i a l Bank R e s e r v e Management i n a S t o c h -a s t i c M o d e l : I m p l i c a t i o n s f o r M o n e t a r y P o l i c y " , J o u r n a l o f F i n a n c e , V o l . 23, N o . 5: 769-79 (Dec . 1968) 8 t e n p e r cen t o f t o t a l C a n a d i a n d e p o s i t l i a b i l i t i e s f rom the a c t u a l r e s e r v e h o l d i n g s o f the s y s t e m . S i n c e t h e r e was no r e q u i r e d r e s e r v e r a t i o i n Canada u n t i l 19 3 5 , where d i d t h i s t e n p e r cent r a t i o come from? There was an i d e a p r e v a l e n t at the t i m e , and s t i l l p r e v a i l i n g , t h a t the banks adhered t o a t e n p e r cent r e s e r v e r a t i o t h r o u g h an u n d e r s t a n d i n g w i t h i n the C a n a d i a n Bankers A s s o c i a t i o n . Was t h i s r a t i o as s t r o n g l y adhered t o as i t was b e l i e v e d ? The f i r s t m e n t i o n o f a t e n p e r c e n t r e s e r v e was by B . E . W a l k e r , E s q . , b e f o r e the Congress o f Bankers and F i n a n c i e r s a t C h i c a g o , June 2 3 , 1893 . " W i t h us no r e s e r v e s are a c t u a l l y r e q u i r e d by l a w . The cash r e s e r v e i n g o l d a n d l e g a l t e n d e r i n g has averaged f o r some y e a r s about t e n p e r c e n t . " On t h e o t h e r h a n d , George Hague s t a t e s : "The o n l y t h i n g t h a t can be t r u l y s a i d about t h i s m a t t e r ( the h o l d i n g o f r e s e r v e s ) i s , as has been s a i d i n t h i s a r t i c l e , t h a t o p i n i o n s d i f f e r . I t i s w e l l known to those whose a c q u a i n -t a n c e w i t h the s u b j e c t i s p r a c t i c a l , that what i s a s t r o n g r e s e r v e t o one bank w o u l d be a weak r e - 1 s e r v e t o a n o t h e r , what w o u l d be a s t r o n g r e s e r v e at one t i m e w o u l d be a weak r e s e r v e at a n o t h e r . " B . E . W a l k e r , E s q . , " P a p e r r e a d b e f o r e the Congre s s o f Bankers and F i n a n c i e r s , C h i c a g o , June. 2 3 , 1893 , The J o u r n a l p f The C a n a d i a n Bankers A s s o c i a t i o n , V o l . 1, P a r t 1, S e p t . 1893 , p . 2 4 . George Hague, "Bank R e s e r v e s " , The J o u r n a l o f the C a n -a d i a n Banker s A s s o c i a t i o n , V o l . 1, p a r t 2 , Dec . 1893 , p . 1 1 0 . 9 A l i t t l e l a t e r i n I n t e r v i e w s on the B a n k i n g and C u r r e n c y Systems o f C a n a d a , " M r . C o u l s o n , a C a n a d i a n B a n k e r , d e c l a r e d t h a t t h e r e was an u n d e r s t a n d i n g among members o f the B a n k e r s ' A s s o c i a t i o n t h a t t h e y were t o m a i n t a i n i n cash an amount e q u a l t o f i f t e e n p e r c e n t - - h o ' p r o b a b l y meant o f d e p o s i t s , though t h i s was n o t made clear . • ' . '21 B . E . W a l k e r , now S i r Edmund W a l k e r a g a i n makes m e n t i o n o f the r e s e r v e r a t i o m a i n t a i n e d by C a n a d i a n comm-e r c i a l banks i n t e s t i m o n y g i v e n i n 1923 . " W e l l , we keep about f rom t e n p e r cent t o t w e l v e p e r cent i n a c t u a l c a s h , t w e n t y t o t h i r t y p e r cen t i n q u i c k l o a n s , and f o r t y t o f i f t y p e r c e n t r e a s o n a b l y q u i c k l y got a t . " 2 2 M e n t i o n i s a l s o made by James H o l l a d a y o f the r e s e r v e s m a i n -t a i n e d by C a n a d i a n B a n k s . "From 1908 t o 1924 , with one e x c e p t i o n , the cash i n hand averaged o v e r t e n p e r cen t o f n e t l i a b i l i t i e s t o the p u b l i c (net l i a b i l i t i e s e q u a l s t o t a l l i a b i l i t i e s to the p u b l i c minus n o t e s o f o t h e r b a n k s , c h e q u e s , o f o t h e r b a n k s , and l o a n s t o o t h e r banks i n Canada) bu t s i n c e the l a t t e r date i t has d e c l i n e d g r a d u a l l y . " 2 3 -F i n a l l y , M r . Graham F . Towers makes m e n t i o n o f the r e s e r v e r a t i o o f t h e C a n a d i a n banks b e f o r e the S t a n d i n g Committee on B a n k i n g and Commerce i n 1939 . I n t e r v i e w s , on t h e B a n k i n g and .Currency System o f Canada. • Senate Document N o . 584 , 61s t C o n g r e s s , 2nd S e s s i o n , W a s h i n g t o n Government P r i n t i n g O f f i c e / 1910 , Q u o t a t i o n from B e n j a m i n H a g g o t t B r e c k h a r t , "The B a n k i n g System o f Canada! ' r e p r i n t e d f rom F o r e i g n B a n k i n g s y s t e r n s , H . H o l t and C o . , New Y o r k , 1929 , p . 430-B e n j a m i n Haggot t B e c k h a r t , "The B a n k i n g System o f C a n a d a " , r e p r i n t e d f rom F o r e i g n B a n k i n g Systems' , H . H o l t and C o . , New Y o r k , 1929 , p . 4 3 5 . James H o l l a d a v . T h e C a n a d i a n B a n k i n g System. . Bankers Pub-l i s h i n g Company, New f o r k , 1938 , p . 8 ^ 7 •2 2 23 10 " I f someone were t o ask me why the c h a r t e r e d banks t r y t o m a i n t a i n a t e n p e r cen t cash r e s e r v e i n s t e a d o f a f i v e p e r cen t o r a f i f -t e e n p e r c e n t , o r some o t h e r f i g u r e , I c o u l d o n l y r e p l y t h a t the w o r k i n g e x p e r i e n c e o f many y e a r s has i n d i c a t e d t h a t t e n p e r cent i s a r e a s o n a b l e r a t i o w h i c h p r o v i d e s s u f f i c i e n t cash to c o v e r any immedia te demands, but i s no t so h i g h as t o c o n s t i t u t e an u n n e c e s s a r y b u r d e n i n the form o f n o n - e a r n i n g a s s e t t s . " ^ ^ , A l t h o u g h t h e r e i s agreement t h a t C a n a d i a n s b a n k s h e l d r e s e r v e s , t h e r e i s no d e f i n i t e s t a t e m e n t t h a t i t was t e n p e r cent e x a c t l y . A l l the s t a t e m e n t s s e e m t o be o f the f o r m , " / r o i t e n t o t w e l v e p e r c e n t " , " a v e r a g e d about t e n p e r c e n t " , " t r y t o m a i n t a i n t e n p e r c e n t " . Cone1us i o n s What r e l a t i o n s h i p does t h i s f i n d i n g have to M o r r i s o n ' s r e s u l t s ? M o r r i s o n f o u n d , by d e t e r m i n i n g exces s r e s e r v e s t o be any r e s e r v e s h e l d above t e n p e r c e n t , t h a t t h e C a n a d i a n b a n k i n g sys tem h e l d l i t t l e o r no exces s r e s e r v e s . In e f f e c t he found t h a t the C a n a d i a n b a n k i n g s y s t e m , f o r some r e a s o n , h e l d a l m o s t a c o n s t a n t t e n p e r cen t r e s e r v e ( s i n c e when he s u b t r a c t e d t e n p e r cent o f C a n a d i a n d e p o s i t l i a b i l i t i e s from a c t u a l ' r e s e r v e s , the d i f f e r e n c e , e i t h e r n e g a t i v e o r p o s i t i v e , was s m a l l ) . T h u s , M o r r i s o n ' s r e s u l t s s u p p o r t the h y p o t h e s i s t h a t M i n u t e s o f P r o c e e d i n g s and E v i d e n c e r e s p e c t i n g the Bank o f Canada o f the S t a n d i n g Committee on B a n k i n g and. Commerce, N o . 1, 1939 , K i n g s P r i n t e r , O t t a w a , 193^ , p . 1 1 . 11 C a n a d i a n c o m m e r c i a l banks .d id adhere to a t e n p e r cent r e s e r v e p o l i c y and seem to i n d i c a t e t h a t the agreed upon t e n p e r cent r e s e r v e was above the range o f changes i n r e s e r v e h o l d i n g s t h a t t h e b a n k i n g sys tem might make i n r e s p o n s e to a l i q u i d i t y p r e f e r e n c e f u n c t i o n , s i n c e the systems' a c t u a l r e s e r v e r a t i o se ldom i f e v e r went above t e n p e r c e n t . How t h e n can I t e s t any model I may c o n s t r u c t t o e x p l a i n bank r e s e r v e h o l d i n g s i f t h e i r r e s e r v e h o l d i n g s r e m a i n c o n s t a n t at t e n p e r c e n t ? There a r e , h o w e v e r , some rea sons f o r c o n t i n u i n g . S i n c e t h e r e was no l e g a l r e s e r v e r e q u i r e m e n t t h e r e was thus no l e g a l d e f i n i t i o n o f what c o n s t i t u t e s r e s e r v e s . T h e r e f o r e , M o r r i s o n ' s r e s u l t s may depend on what he d e c i d e d t o i n c l u d e i n r e s e r v e s . For e x a m p l e , i f he l e a v e s out o f r e s e r v e s some a s s e t w i t h w h i c h t h e banks make most o f t h e i r d e s i r e d changes i n r e s e r v e s , t h e n h i s r e s u l t i n g r e s e r v e r a t i o w o u l d have much more s t a b i l i t y t h a n i t s h o u l d . A l s o h i s d a t a are f o r t h e C a n a d i a n b a n k i n g sy s tem as a w h o l e . The i n d -i v i d u a l banks may have v a r y i n g r e s e r v e r a t i o s w i t h changes i n t h e i r r a t i o s o f f s e t t i n g each o t h e r l e a v i n g the sy s tem r a t i o f a i r l y c o n s t a n t . F i n a l l y , h i s d a t a are an a n n u a l a v e r a g e ' o f month-end f i g u r e s . T h i s a n n u a l average .may h i d e c o n s i d e r a b l e v a r i a t i o n o v e r a g i v e n y e a r . 12 There does seem t o be t h e n some r e a s o n f o r c o n -s t r u c t i n g a l i q u i d i t y p r e f e r e n c e f u n c t i o n (demand f u n c t i o n f o r r e s e r v e s ) f o r C a n a d i a n banks and t e s t i n g i t w i t h m o n t h l y d a t a . CHAPTER TWO A MODEL OF BANK RESERVE BEHAVIOUR I n t r o d u c t i o n Why does a bank h o l d r e s e r v e s ? I s i t o n l y because i t i s f o r c e d t o by law or i s t h e r e some o t h e r , perhaps economic reason f o r d o i n g so? I n t h i s c h a p t e r , I w i l l f i r s t o f a l l i n v e s t i g a t e p o s s i b l e reasons f o r a bank's h o l d i n g r e s e r v e s . Then a f t e r l o o k i n g a t two s t u d i e s which i n v e s t i g a t e d a banks demand f o r r e s e r v e s , I w i l l p r e s e n t my own e m p i r i c a l model, t o be t e s t e d i n t h i s p a p e r , w i t h an e x p l a n a t i o n o f t h e v a r i a b l e s c o n t a i n e d t h e r i n . Why a demand f o r Reserves? A bank must be ready a t a l l times t o a l l o w i t s d e p o s i t o r s t o withdraw i m m e d i a t e l y p a r t o r a l l o f the money e n t r u s t e d t o the bank. I f the bank f a i l s t o meet a demand f o r w i t h d r a w a l o f f u n d s , i t w i l l p r o b a b l y cease o p e r a t i o n s as a bank? Many of the w i t h d r a w a l s may be r e - d e p o s i t e d v e r y q u i c k l y i n the same bank o r may be o f f s e t by c o m p l e t e l y new d e p o s i t s . A l s o i f i t was n e c e s s a r y t o g i v e n o t i c e o f w i t h d r a w a l the banks c o u l d p l a n t o have some o f i t s e a r n i n g a s s e t s mature a t such a time as they c o u l d be c o n v e r t e d i n t o c u r r e n c y _ The Bank A c t s t a t e s t h a t "any s u s p e n s i o n by the bank o f payment of any o f i t s l i a b i l i t i e s as they a c c r u e , i n Bank o f Canada notes (Dominion notes b e f o r e t h e e s t a b l i s h m e n t o f the Bank o f Canada) i f i t c o n t i n u e s f o r n i n e t y days c o n s e c u t i v e l y , o r a t i n t e r v a l s w i t h i n t w e l v e c o n s e c u t i v e months, c o n s t i t u t e s t h e bank insolvent 1.' Canada, An A c t R e s p e c t i n g Banks and B a n k i n g , Queen's P r i n t e r , Ottawa, 1954. However, b e f o r e the bank became l e g a l l y i n s o l v e n t , any i n a b i l i t y t o meet a w i t h d r a w a l demand would r e s u l t i n a l o s s o f p u b l i c con-f i d e n c e and a p o s s i b l e r u n on the bank. 14 a c c e p t a b l e t o t h e . w i t h d r . a w e r . - Inasmuch as the above s i t u a t i o n s do not h o l d , t h a t i s w i t h d r a w a l s are no t so q u i c k l y r e - d e p o s i t e d i n the same b a n k , new d e p o s i t s do n o t o f f s e t w i t h d r a w a l s o r a w i t h d r a w e r does n o t have t o g i v e n o t i c e , i t w i l l be n e c e s s a r y f o r a bank to h o l d some o f i t s a s s e t s i n the form o f n o n - i n t e r e s t e a r n i n g , h i g h l y l i q u i d a s se t s : c a l l e d r e s e r v e s . I f h e l d as c a s h , t h e s e r e s e r v e s do n o t e a r n i n t e r e s t and t h e r e i s a c o s t to h o l d i n g them i n the form o f the o p p o r t u n i t y c o s t fo regone by h o l d i n g t h e s e r e s e r v e s r a t h e r t h a n s e c u r i t i e s o r l o a n s . T h u s , as i n t e r e s t r a t e s on l o a n s and s e c u r i t i e s r i s e a bank would t e n d t o reduce i t s r e s e r v e h o l d i n g s because o f the r i s i n g o p p o r t u n i t y c o s t o f them. L i k e w i s e i f ra tes , are f a l l i n g or i f the chance o f a c a p i t a l l o s s from h o l d i n g t h e s e o t h e r a s s e t s i s r i s i n g the o p p o r t u n i t y c o s t o f h o l d i n g r e s e r v e s w i l l f a l l and thus the amount o f r e s e r v e s h e l d may r i s e . Banks may have o t h e r means o f m e e t i n g sudden w i t h d r a w a l s t h a n s i m p l y r e l y i n g on t h e i r own r e s o u r c e s . That i s t h e y may be a b l e t o b o r r o w e i t h e r from o t h e r c o m m e r c i a l banks o r a c e n t r a l b a n k . Why n o t t h e n a t t e m p t t o m i n i m i z e r e s e r v e h o l d i n g s and b o r r o w when n e c e s s a r y t o meet w i t h - • d r a w a l s ? There i s , h o w e v e r , a l s o a c o s t t o b o r r o w i n g . 15 Thus, n o t o n l y i s t h e r e a c o s t t o h o l d i n g t o o many r e s e r v e s , t h e r e i s a l s o a c o s t t o n o t h o l d i n g enough. How th e n does a bank d e c i d e how much cash r e s e r v e s t o h o l d ? Does i t s i m p l y a d j u s t i t s r e s e r v e h o l d i n g s e i t h e r downward, i f the c o s t o f meeting a d e f i c i e n c y (borrowing) f a l l s w h i l e the o p p o r t u n i t y c o s t r i s e s o r upwards i f they move i n the o p p o s i t e d i r e c t i o n ? Banks are p r o b a b l y a b l e t o form a s u b j e c t i v e p r o b a b i l i t y d i s t r i b u t i o n o f p o s s i b l e n e t cash f l o w s . T h i s means f i r s t o f a l l t h a t n e t cash f l o w s a re n o t c o n s t a n t . The bank never knows e x a c t l y how much o f a cash f l o w w i l l o c c u r a t any g i v e n time b u t i t a l s o means t h a t t h e y do form a d i s t r i b u t i o n o f p o s s i b l e n e t cash f l o w s and t h i s s u b j e c t i v e d i s t r i b u t i o n changes o v e r time as c e r t a i n v a r i a b l e s change. Thus, they w i l l use t h i s s u b j e c t i v e p r o b a b i l i t y o f p o s s i b l e n e t cash f l o w s a l o n g w i t h the p e n a l t y c o s t o f a ca s h de-f i c i e n c y and t h e o p p o r t u n i t y c o s t o f h o l d i n g r e s e r v e s when d e c i d i n g how much o f r e s e r v e s they w i l l h o l d . F o r example, a f t e r d e c i d i n g on a c e r t a i n range o f n e t cash f l o w s , w h i c h may o c c u r , they would t h e n l o o k a t the c o s t o f e r r i n g on e i t h e r s i d e o f the e x p e c t e d n e t cash f l o w . That i s , i f the y h o l d a l i t t l e more than the e x p e c t e d n e t cash f l o w t h i s w i l l have a c e r t a i n o p p o r t u n i t y c o s t . I f t h i s oppor-t u n i t y c o s t i s low they may d e c i d e t o have t h i s e x t r a m argin o f s a f e t y . L i k e w i s e i f they h o l d l e s s t h a n t h e e x p e c t e d n e t cash f l o w t h i s a l s o w i l l have a c o s t , namely 16 t h e c o s t o f m e e t i n g a c a s h d e f i c i e n c y . I f t h i s c o s t i s l ow t h e y may be w i l l i n g t o t a k e t h e c h a n c e . I n t h e l o n g r u n , a b a n k ' s h o l d i n g o f r e s e r v e s may a l s o be a f f e c t e d by economies o f s c a l e . As a bank grows i n s i z e , t h e a b s o l u t e amount o f r e s e r v e s h e l d w i l l r i s e b u t t h e r e s e r v e r a t i o may f a l l . These economies o f s c a l e w o u l d o c c u r because o f g r e a t e r speed i n p r o c e s s i n g bank b u s i n e s s ( t h a t may r e s u l t as t h e bank grows) t h u s r e d u c i n g t h e amount o f c a s h needed t o h a n d l e a g i v e n amount o f b u s i -n e s s . They may a l s o r e s u l t f rom g r e a t e r s o p h i s t i c a t i o n ( l i k e -w i s e r e s u l t i n g f rom l a r g e r bank s i z e ) i n p r e d i c t i n g w i t h d r a w a l s , a l l o w i n g t h e bank t o h o l d a l e s s e r p e r c e n t a g e o f i t s d e p o s i t l i a b i l i t i e s as r e s e r v e s . I f t h e b a n k , w h i l e g r o w i n g i n s i z e , i s a l s o g r o w i n g r e l a t i v e t o i t s c o m p e t i t o r s o r i f t h e number o f banks i n t h e s y s t e m i s d e c l i n i n g t h e n t h e chance o f a w i t h d r a w a l b e i n g r e - d e p o s i t e d i n t h e same bank i n c r e a s e s and t h u s t h e r e -s e r v e r a t i o may f a l l . F i n a l l y , t h e l a r g e r t h e b a n k , t h e l e s s i t need w o r r y a b o u t i n d i v i s i b i l i t y o f i t s a s s e t s . I n o t h e r w o r d s , a s m a l l e r bank w o u l d have t o h o l d a g r e a t e r p e r c e n t a g e o f i t s a s s e t s as r e s e r v e s because w i t h i t s s m a l l e r p o r t f o l i o i t w o u l d n o t be a b l e t o o p e r a t e as c l o s e t o any g i v e n p e r c e n t a g e as w o u l d a l a r g e b a n k . M o r r i s o n ' s mode l An a t t e m p t t o i n c o r p o r a t e most o f t h e above p o i n t s i n a t h e o r e t i c a l m o d e l o f a b a n k s ' demand f o r r e s e r v e s was 17 • made by George M o r r i s o n i n h i s book., L i q u i d i t y : P r e f e r e n c e s 25 o f Commerc i a l - B a n k s . He b e g i n s by c o n s t r u c t i n g an e x p e c t e d l o s s f u n c t i o n f o r the demand f o r r e s e r v e s . I t i s assumed t h a t a bank w i l l a t t e m p t to m i n i m i z e i t s e x p e c t e d l o s s d u r i n g a c e r t a i n t i m e p e r i o d by an a p p r o p r i a t e . a l l o c a t i o n o f i t s a s s e t s between cash r e s e r v e s and l o a n s . In making t h i s a l l o c a t i o n the bank i s f a c e d w i t h c e r t a i n v a r i a b l e s such a s : 1. the r e t u r n p e r d o l l a r o f l o a n s , composed o f an i n t e r e s t component (y) and an e x p e c t e d c a p i t a l g a i n or l o s s component (g) w h i c h p o s s e s s e s some p r o b a b i l i t y d e n s i t y ( 0 ( g ) ) . 2 . an e x p e c t e d change i n cash r e s e r v e s e x p r e s s e d as a p r o p o r t i o n (v) o f i n i t i a l , d e p o s i t s w i t h (v) p o s s e s s i n g a p r o b a b i l i t y d e n s i t y f ( v ) . 3 . a p e n a l t y c o s t o f m e e t i n g a cash d e f i c i e n c y ( h ) . L e t t i n g p be cash as a r a t i o t o i n i t i a l d e p o s i t s the e x p e c t e d l o s f u n c t i o n i s w r i t t e n as f o l l o w s : E [L(.p)] = yP + P\ g0 ( g )dg +\ P n ( ~ v - P ) f ( v ) d v . ^ - 1 -J c From t h i s can be d e r i v e d a demand e q u a t i o n f o r r e s e r v e s as a f u n c t i o n o f the above terms and. a l s o ( k ) , the range o f the 25. 26 C h i c a g o , U n i v e r s i t y o f C h i c a g o P r e s s , 1966 , p p . 8 - 1 1 . I t i s assumed t h a t the bank has o n l y a c h o i c e between cash r e s e r v e s and l o a n s . The te rm l o a n s r e p r e s e n t s i n an .unde-f i n e d way the whole s p e c t r u m o f a s s e t s o t h e r t h a n r e s e r v e s w h i c h are open t o a b a n k . I f the c h o i c e between a l l a s s e t s was i n c o r p o r a t e d e x p l i c i t l y i n t o the m o d e l , i t wou ld become a p r o b l e m i n p o r t f o l i o s e l e c t i o n , a n o t h e r f i e l d a g a i n , w h i c h would u n n e c e s s a r i l y c o m p l i c a t e m a t t e r s when o u r : i n t e r e s t i s s i m p l y i n the b a n k e r s cash r e s e r v e b e h a v i o u r . 18 27 d i s t r i b u t i o n o f e x p e c t e d c a s h f l o w s . (Y + g) P = k ( l - n ) - v 2 I f t h i s demand e q u a t i o n i s d i f f e r e n t i a t e d w i t h r e s p e c t t o P we f i n d t h a t t h e model p r e d i c t s a d i r e c t r e l a t i o n -s h i p between t h e demand f o r c a s h r e s e r v e s and t h e p e n a l t y c o s t o f a c a s h d e f i c i e n c y (n) and an i n v e r s e r e l a t i o n s h i p between t h e demand f o r c a s h r e s e r v e s and t h e i n t e r e s t r a t e on l o a n s ( y ) , t h e e x p e c t e d c a p i t a l g a i n o r l o s s on l o a n s (g) and t h e e x p e c t e d c a s h i n f l o w (v) and a c h a n g i n g r e l a t i o n s h i p be tween t h e demand f o r c a s h r e s e r v e s and t h e range o f t h e d i s t r i b u t i o n o f e x p e c t e d c a s h f l o w s (k). A mode l s i m i l a r t o t h e above was t h e n t e s t e d e m p i r i c a l l y u s i n g A m e r i c a n d a t a . T h u s , M o r r i s o n a s s e r t s t h a t t h e r e e x i s t s a bank demand f o r c a s h r e s e r v e s , i r r e s p e c t i v e o f any r e s e r v e s t h a t t h e bank m i g h t be r e q u i r e d t o h o l d by l a w . S i n c e he was d e a l i n g w i t h a g g r e g a t e d a t a i n t h e f o r m o f g roups o f b a n k s , economies o f s c a l e w i t h r e g a r d s t o r e s e r v e h o l d i n g s was o f no r e l e v a n c e t o h i m . A l s o because o f t h e use o f a g g r e g a t e d a t a t h e a g g r e g a t i o n p r o b l e m i s p r e s e n t b u t i t s e f f e c t i s unknown. M o r r i s o n , Op. c i t . , p . 1 0 , t h e demand e q u a t i o n i s d e r i v e d f rom t h e e x p e c t e d l o s s f u n c t i o n . 19 G o 1 d f e l d ' s mode1. 2 8 Stephen G o l d f e l d , as p a r t o f a l a r g e r s t u d y o f c o m m e r c i a l bank p o r t f o l i o b e h a v i o u r , t e s t s e m p i r i c a l l y two bank d e m a n d . e q u a t i o n s , one f o r exces s r e s e r v e s and a n o t h e r f o r b o r r o w i n g s from the F e d e r a l R e s e r v e , the two t o g e t h e r f o r m i n g f r e e r e s e r v e s . The demand f o r exces s r e s e r v e s he has as a f u n c t i o n o f the T r e a s u r y b i l l r a t e , a l a g g e d v a l u e o f exce s s r e s e r v e s , s e a s o n a l dummy v a r i a b l e s , v a r i o u s c o n s t r a i n t v a r i a b l e s such as d e p o s i t f l o w s o f v a r i o u s t y p e s , a v a r i a b l e i n c o r p o r a t i n g changes i n the average r e s e r v e r e q u i r e m e n t o f each c l a s s o f bank and a dummy v a r i a b l e t o t ake a c c o u n t o f a s t r u c t u r a l s h i f t w h i c h took p l a c e a f t e r the F e d e r a l R e s e r v e -T r e a s u r y A c c o r d o f 1 9 5 1 . S e p a r a t e l y he t e s t s e m p i r i c a l l y the demand f o r b o r r o w i n g s f rom the F e d e r a l Reserve as a f u n c t i o n o f t h e d i f f e r e n c e between t h e d i s c o u n t r a t e and the T r e a s u r y b i l l r a t e , s e a s o n a l dummy v a r i a b l e s , and the same c o n s t r a i n t v a r i a b l e s as i n the demand f o r exces s r e s e r v e s e q u a t i o n . The above s e p a r a t i o n o f f r e e r e s e r v e s i n t o exces s r e s e r v e s and b o r r o w e d r e s e r v e s w i t h a s e p a r a t e demand e q u a t i o n f o r each i s a s t e p f o r w a r d i n the a n a l y s i s o f the A m e r i c a n b a n k i n g s i t u a t i o n and i t c o u l d be a p p l i e d to the C a n a d i a n b a n k i n g sy s tem a l s o i f i n s t e a d o f exce s s r e s e r v e s we use t o t a l r e s e r v e s ( s i n c e t h e r e were no r e q u i r e d r e s e r v e s , exces s r e s e r v e s i s m e a n i n g l e s s ) and i n s t e a d o f b o r r o w i n g from a S tephen G o l d f e l d , C o m m e r c i a l Bank B e h a v i o u r and Economic A c t i v i t y . , . Amsterdam, N o r t h - H o l l a n d , 1966 , pp 4 - 5 3 . • 20 c e n t r a l bank we use bank b o r r o w i n g under the. F i n a n c e A c t . However , i n t h i s s t u d y I w i l l n o t i n c l u d e an a n a l y s i s o f bank b o r r o w i n g under the F i n a n c e A c t b u t w i l l f ocus o n l y 29 on banks cash r e s e r v e b e h a v i o u r . Because o f the l a r g e number o f A m e r i c a n b a n k s , G o l d f e l d , l i k e M o r r i s o n , used aggrega te d a t a t o t e s t h i s demand e q u a t i o n s w i t h the r e s u l t a n t unknown b i a s e s because / . .Aggrega t ion and a l s o the i n a b i l i t y to t e s t t h e e f f e c t o f d i f f e r e n c e s among banks on the h o l d i n g o f r e s e r v e s . The Model t o be t e s t e d -Because o f one o f the c h a r a c t e r i s t i c s o f the C a n a -d i a n b a n k i n g s y s t e m , namely, the s m a l l number o f b a n k s , I - w i l l -i n v e s t i g a t e : the r e s e r v e b e h a v i o u r o f the banks on an i n d i v i d u a l b a s i s and t h u s , u n l i k e the two p r e v i o u s s t u d i e s may be a b l e to d e t e r m i n e the e f f e c t o f d i f f e r e n c e s between banks on the h o l d -i n g o f r e s e r v e s . The a g g r e g a t i o n p r o b l e m , w h i c h r e s u l t s from u s i n g aggrega te d a t a f o r a group o f banks o r a whole b a n k i n g sy s tem t o t e s t a model o f i n d i v i d u a l bank r e s e r v e b e h a v i o u r w i l l a l s o be a l l e v i a t e d . By t h e use o f m o n t h l y d a t a the p r o b l e m o f a g g r e g a t i o n o v e r t i m e p e r i o d s w i l l l i k e w i s e be r e d u c e d . I t w o u l d o n l y b e - e l i m i n a t e d i f the b a n k s . p l a n n i n g C a n a d i a n c o m m e r c i a l ,b.ank b o r r o w i n g under, the F i n a n c e A c t has been i n v e s t i g a t e d -by E r i c Sven K e r r , The D e t e r m i n a n t s o f Bank B o r r o w i n g under the F i n a n c e A c t 1914 - 19 3 4 , E r i k Sven K e r r , M . A . T h e s i s , U . B . C , 1967 . 21 p e r i o d were one month and i f t h e d a t a were m o n t h l y average 30 f i g u r e s , n e i t h e r o f w h i c h i s t h e ca se h e r e . The a c t u a l mode l I w i l l t e s t t o e x p l a i n t h e r e s e r v e h o l d i n g b e h a v i o u r o f i n d i v i d u a l C a n a d i a n c o m m e r c i a l banks i s t h e f o l l o w i n g : P = f ( n , r f y, 0 , c , h , I , G , S) where n i s t h e r a t e o f i n t e r e s t on b o r r o w i n g under t h e F i n a n c e A c t r i s t h e New Y o r k c a l l l o a n r a t e y i s i m p o r t s c i s r a i l r o a d c a r l o a d i n g s 0 i s i n t e r e s t r a t e on l o n g t e r m O n t a r i o Government bonds h i s a r a t i o o f demand t o t o t a l d e p o s i t s 1 i s a r a t i o o f i n t e r b a n k t o t o t a l d e p o s i t s G i s a r a t i o o f t h i s m o n t h ' s d e p o s i t s t o l a s t m o n t h ' s . S i s a bank s i z e v a r i a b l e . The above m o d e l u se s t h e e m p i r i c a l c o u n t e r p a r t s o f s e v e r a l o f t h e v a r i a b l e s f rom M o r r i s o n ' s t h e o r e t i c a l m o d e l p r e s e n t e d e a r l i e r . S e v e r a l o t h e r v a r i a b l e s a re added because o f my use o f i n d i v i d u a l bank d a t a . A l s o one v a r i a b l e , e x p e c t e d c a p i t a l g a i n s o r l o s s e s on l o a n s , i s n o t i n c l u d e d i n my e m p i r i c a l m o d e l because w i t h t h e l a c k o f i n t e r e s t r a t e d a t a i n Canada f o r 30 H . T h e i l , L i n e a r A g g r e g a t i o n o f E c o n o m i c R e l a t i o n s , Amsterdam, N o r t h - H o l l a n d , 1954 , and R.G.D. A l l e n , M a t h e m a t i c a l E c o n - omics , L o n d o n , M a c m i l l a n , 1 9 5 7 , p p . 6 9 4 - 7 1 9 . E i t h e r o f t h e s e books can be r e f e r r e d t o f o r more on t h e a g g r e g a t i o n p r o b l e m . t h e p e r i o d u n d e r s t u d y i t w i l l be i m p o s s i b l e t o measure i t . 3 1 I n any c o u n t r y w h e r e t h e r e i s a c e n t r a l b a n k , t h e p e n a l t y c o s t o f a c a s h d e f i c i e n c y i s i n d i c a t e d by t h e c e n t r a l bank d i s c o u n t r a t e ( the r a t e t h a t banks pay on b o r r o w i n g s f rom t h e c e n t r a l b a n k ) . I n C a n a d a , no s u c h c e n t r a l bank e x -i s t e d d u r i n g most o f t h e p e r i o d u n d e r s t u d y . However , t h e C a n a d i a n banks d i d have a s o u r c e o f b o r r o w e d funds i n t h e f o r m o f b o r r o w i n g s u n d e r t h e F i n a n c e A c t . O r i g n a l l y e s t -a b l i s h e d as a w a r t i m e measure t o e n s u r e b a n k ' s l i q u i d i t y i t was c o n t i n u e d a f t e r t h e war i n g r a d u a l l y c h a n g i n g f o r m . The p r o v i s i o n o f i m p o r t a n c e t o us h e r e c o n c e r n s t h e a d v a n c i n g o f D o m i n i o n n o t e s t o t h e c h a r t e r e d b a n k s upon t h e p l e d g e o f a p p r o v e d s e c u r i t i e s d e p o s i t e d w i t h t h e M i n i s t e r o f F i n a n c e . T h i s p a r t o f t h e A c t was renewed u n d e r t h e F i n a n c e A c t o f 1923 and c o n -t i n u e d u n t i l t h e e s t a b l i s h m e n t o f t h e Bank o f Canada i n 1935 . T h e r e f o r e , as t h e p e n a l t y c o s t o f a c a s h d e f i c i e n c y (n) f o r t h e b a n k s , I w i l l use t h e r a t e o f i n t e r e s t c h a r g e d o© bank b o r r o w i n g under t h e F i n a n c e A c t , u n t i l 19 3 5 , a f t e r w h i c h i t i s t h e d i s c o u n t r a t e o f t h e Bank o f C a n a d a . T h i s p e n a l t y c o s t o f b o r r o w i n g s h o u l d have a d i r e c t r e l a t i o n s h i p w i t h b a n k ' s r e s e r v e h o l d i n g s . E x p e c t e d c a p i t a l g a i n s o r l o s s e s a r e measured by t h e s p r e a d between l o n g t e r m and s h o r t t e r m i n t e r e s t r a t e s . 23 I n f o r m a t i o n on i n t e r e s t r a t e s i n Canada d u r i n g t h e p e r i o d under s t u d y i s v e r y s c a r c e . A l o n g t e r m i n t e r e s t r a t e s e r i e s on O n t a r i o Government bonds i s a v a i l a b l e (and w i l l be t e s t e d ) b u t s i n c e t h e b a n k ' s t r a d e -o f f w o u l d be be tween c a s h r e s e r v e s and v e r y s h o r t t e r m s e c u r i t i e s , a s h o r t t e r m i n t e r e s t r a t e w o u l d p r o b a b l y be a b e t t e r d e t e r m i n a n t o f c a s h r e s e r v e b e h a v i o u r . T h e r e i s no C a n a d i a n s h o r t t e r m i n t e r e s t r a t e a v a i l a b l e f o r t h e p e r i o d u n d e r s t u d y . G i v e n t h e f a c t t h a t t h e C a n a d i a n banks p l a y e d an i m p o r t a n t r o l e i n t h e New Y o r k money m a r k e t and i n d e e d u s e d i t as t h e p r i m a r y p l a c e f o r a d j u s t i n g t h e i r l i q u i d i t y p o s i t i o n s , t i l e r e l e v a n t s h o r t t e r m r a t e f o r t h e C a n a d i a n c o m m e r c i a l banks w o u l d be t h e New Y o r k c a l l l o a n r a t e . The t h e o r e t i c a l m o d e l s t a t e s t h a t t h e r e l a t i o n -s h i p between r e s e r v e s h e l d and t h e l o a n r a t e (under w h i c h t h e s e c u r i t y r a t e i s i n c l u d e d as e x p l a i n e d i n f o o t n o t e 26) w i l l be i n v e r s e . T h i s l a c k o f i n t e r e s t r a t e i n f o r m a t i o n a l s o a p p l i e s t o t h e l o a n s i t u a t i o n . I n t h i s case I u s e , r a t h e r t h a n i n t e r e s t r a t e s , some v a r i a b l e s t o i n d i c a t e t h e demand f o r l o a n s w h i c h I p o s t u l a t e w i l l a l s o have an i n v e r s e r e l a t i o n -s h i p w i t h r e s e r v e h o l d i n g s . T h i s a l l o w s me t o g e t a round t h e l a c k o f i n t e r e s t r a t e d a t a b u t a l s o i t i s good f o r t h e f o l l o w i n g r e a s o n . T h e r e was and s t i l l i s a b e l i e f p r e v a l e n t 24 among C a n a d i a n b a n k e r s (and p r o d u c e d p r o b a b l y by t h e i r v u l n e r a b i l i t y t o p u b l i c o p i n i o n because o f t h e i r s m a l l numbers) t h a t the main pupose o f the C a n a d i a n banks i s t o make l o a n s . Because o f t h i s t h e y may r e s p o n d more t o the a c t u a l demand f o r l o a n s r a t h e r t h a n to the p r o f i t m o t i v e i n the form o f i n t e r e s t ea rned on l o a n s when d e c i d -i n g t o g r a n t more o r l e s s l o a n s and thus draw down or b u i l d up t h e i r r e s e r v e s . A l s o i n most i n s t a n c e s , the two' w i l l move t o g e t h e r . That i s when the demand f o r l o a n s i s h i g h thus e n c o u r a g i n g banks t o make l o a n s and draw down t h e i r r e s e r v e s , the i n t e r e s t r a t e on l o a n s w i l l a l s o be h i g h , making i t p r o f i t a b l e f o r the banks t o g r a n t l o a n s . I f at any t i m e the demand f o r l o a n s and the i n t e r e s t r a t e on l o a n s do n o t move t o g e t h e r i n the same d i r e c t i o n i t w i l l be the demand f o r l o a n s w h i c h governs the banks g r a n t i n g o f l o a n s and thus t h e i r h o l d i n g o f r e s e r v e s . . I would argue t h e n t h a t a v a r i a b l e r e p r e s e n t i n g the demand f o r l o a n s w i l l be a b e t t e r d e t e r m i n a n t o f the banks r e s e r v e h o l d i n g s t h a n the i n t e r e s t r a t e on l o a n s and f u r t h e r t h a t t h e r e w i l l be an i n v e r s e r e l a t i o n s h i p between the demand f o r l o a n s and the banks h o l d i n g s o f r e s e r v e s . A good v a r i a b l e t o r e p r e s e n t the demand f o r l o a n s w o u l d be some measure o f the l e v e l o f economic a c t i v i t y such as g ros s n a t i o n a l p r o d u c t o r i n d u s t r i a l p r o d u c t i o n . The r e a s o n i s t h a t when t h e l e v e l o f economic a c t i v i t y i s h i g h , s o a l s o w i l l be t h e demand f o r l o a n s as p e o p l e r e v i s e upward t h e i r c o n s u m p t i o n p a t t e r n s and b u s i n e s s e s i n c r e a s e c a p i t a l e x p e n d i t u r e s , b o t h groups f i n a n c i n g p a r t o f t h i s e x -p e n d i t u r e t h r o u g h l o a n s . However , a g a i n we e n c o u n t e r t h e p r o b l e m o f l a c k o f d a t a f o r t h e p e r i o d u n d e r s t u d y . S i n c e t h e l e v e l o f i m p o r t s i s t i e d v e r y c l o s e l y t o g r o s s n a t i o n a l 32 p r o d u c t o r i n d u s t r i a l p r o d u c t i o n , I w o u l d p o s t u l a t e t h a t t h e l e v e l o f i m p o r t s w o u l d be a good p r o x y f o r t h e demand f o r l o a n s , t h e movements i n b o t h b e i n g c l o s e l y r e l a t e d . The demand f o r l o a n s w o u l d a l s o v e r y s e a s o n a l l y . Of p a r t i c u l a r i m p o r t a n c e i n Canada i s t h e l a r g e p a r t t h a t c o m m e r c i a l banks p l a y i n t h e f i n a n c i n g o f a g r i c u l t u r e and i n p a r t i c u l a r c r o p movements . S i n c e a g r i c u l t u r e was s u c h a l a r g e s e c t o r o f t h e C a n a d i a n . e c o n o m y d u r i n g t h e p e r i o d u n d e r s t u d y , c r o p movements w o u l d p r o b a b l y have a g r e a t i n f l u e n c e on t h e demand f o r l o a n s and t h u s t h e h o l d i n g o f r e s e r v e s . C r o p movements w i l l be r e p r e s e n t e d i n t h e model by r a i l r o a d c a r l o a i g s . As g r o s s n a t i o n a l p r o d u c t and t h u s incomes i n c r e a s e , c o n s u m p t i o n a l s o i n c r e a s e s and s i n c e f o r Canada a l a r g e p a r t o f o u r c o n s u m p t i o n c o n s i s t s o f f o r e i g n made goods o r f o r e i g n s u p p l i e d s e r v i c e s , i m p o r t s a l s o w i l l i n c r e a s e c o r r e s p o n d i n g l y . L i k e w i s e as i n d u s t r i a l p r o d u c t i o n i n c r e a s e s much o f t h e new c a p i t a l e q u i p m e n t u s e d i n p r o d u c t i o n i s i m p o r t e d . 26 N o t o n l y w i l l t h e demand f o r loans , a f f e c t t h e banks d e s i r e f o r r e s e r v e s , d e c r e a s i n g i t d u r i n g t i m e s o f h i g h demand f o r l o a n s and v i c e v e r s a , b u t t h e demand f o r l o a n s w i l l a l s o a f f e c t t h e c a s h d r a i n s on a b a n k . When p e o p l e . t a k e o u t a l o a n , t h e y a re n o t l i k e l y t o l e a v e i t s i t t i n g i d l y i n t h e b a n k . A l s o some p e o p l e w i l l w i t h -draw t h e i r own funds f r o m t h e bank t o meet t h e needs w h i c h prompted t h e i n c r e a s e d demand f o r l o a n s . The 3 3 amount o f w i t h d r a w a l s f r o m a bank w i l l t h e n i n c r e a s e as t h e demand f o r l o a n s i n c r e a s e s . To t h e e x t e n t The banks c o u l d meet t h i s c a s h d r a i n by i s s u i n g t h e i r own n o t e s w h i c h were n o t p a r t o f c a s h r e s e r v e s . However , any n o t e s i n c i r c u l a t i o n above t h e amount o f a banks u n i m p a i r e d p a i d -up c a p i t a l had t o be matched by a d e p o s i t o f g o l d o r D o m i n i o n n o t e s i n t h e C e n t r a l G o l d R e s e r v e s . S i n c e most banks u s u a l l y had t h a t banks can p r e d i c t such d r a i n s they may be a b l e t o meet them w i t h o u t drawing down t h e i r r e s e r v e s . T h i s may be done by p l a n n i n g i n t h e i r s e c u r i t i e s p o r t f o l i o f o r c e r t a i n i s s u e s t o come due a t the same time the c a s h w i l l be needed. To the e x t e n t t h a t they f a i l t o p r e d i c t e x a c t l y , then t h e i r r e -s e r v e s may f a l l even l o w e r than the low l e v e l d e s i r e d by the banks because of the i n c r e a s e d demand f o r l o a n s . (Continued) n o t e s i n c i r c u l a t i o n above the amount (as w i t n e s s e d by a s t a t e m e n t made by S i r Edmund Walker t h a t " the bank i s u s i n g i t s f u l l c i r c u l a t i o n a g a i n s t c a p i t a l " 34) a n y w i t h d r a w a l o f funds by d e p o s i t o r s would a f f e c t cash r e s e r v e s . H.P. W i l l i s and B.H. B e c k h a r t , ed., F o r e i g n B a n k i n g  Systems, New Y o r k , Henry H o l t , p"^  386. 2 8 In summary t h e n , the demand f o r loans w i l l be a b e t t e r determinant o f r e se rve b e h a v i o u r than i n t e r e s t r a t e s on loans and the demand f o r loans w i l l be r e p r e s e n t e d i n my model by the l e v e l o f i m p o r t s , and r a i l r o a d c a r l o a d -i n g s . I n c r e a s e d . w i t h d r a w a l s from the banks , as a r e s u l t o f the i n c r e a s e d demand f o r l o a n s , w i l l i n c r e a s e the t e n -dency f o r the banks re se rve r a t i o to f a l l . The r e l a t i o n -s h i p then between the demand f o r loans and the h o l d i n g o f r e se rve s w i l l be i n v e r s e . A c c o r d i n g to M o r r i s o n ' s t h e o r e t i c a l model , the demand f o r r e se rve s w i l l be a f f e c t e d by the expected Cash f low and the range o f the d i s t r i b u t i o n o f p o s s i b l e cash f l o w s . In o ther words the banks form an i d e a about the d i s t r i b u t i o n o f p o s s i b l e cash f l o w s . T h i s t h e o r e t i c a l d i s t r i b u t i o n w i l l be a f f e c t e d by such t h i n g s as the p e r -centage of a b a n k s ' d e p o s i t s , which are demand d e p o s i t s , the percentage o f a banks ' d e p o s i t s which are interbank^ d e p o s i t s and the r a t i o o f t h i s m o n t h s ' d e p o s i t s to l a s t . The g r e a t e r the percentage o f a bank ' s d e p o s i t s which are demand d e p o s i t s the g r e a t e r the chance o f a sudden wi thdrawal t a k i n g p l a c e which must be met i m m e d i a t e l y . An i n c r e a s e i n the percentage o f demand d e p o s i t s would i n -crease the e x p e c t a t i o n o f a cash d r a i n and thus a l so i n c r e a s e the re se rves h e l d . I f a bank has a l a rge amount o f i n t e r b a n k d e p o s i t s and thus acts as a bankers bank, the expectation o f a 29 c a s h d r a i n p r o b a b l y i n c r e a s e s and a l s o t h e r a n g e o f t h e d i s t r i b u t i o n i n c r e a s e s . In o t h e r words t h e s i z e o f t h e w i t h d r a w a l may be much l a r g e r t h a n w i t h an o r d i n a r y 3 6 d e p o s i t . F i n a l l y i f a b a n k s d e p o s i t s h a v e jumped t r e m e n d o u s l y f r o m one month t o t h e n e x t b e c a u s e o f l a r g e new d e p o s i t s , t h e bank may a t f i r s t e x p e c t a s u d d e n l a r g e w i t h d r a w a l u n t i l i t becomes a c c u s t o m e d t o t h e new h i g h e r l e v e l o f d e p o s i t s and t h e n makes t h e n e c e s s a r y a d j u s t m e n t s i n i t s p o r t f o l i o . A l s o i t t a k e s t i m e f o r t h e bank t o c a r r y o u t t h e d e s i r e d c h a n g e s and w o r k i n g w i t h m o n t h l y d a t a we h a v e t o a l l o w f o r t h i s l a g i n r e s p o n s e . T h u s i we w o u l d e x p e c t t h a t i f a bank h a d e x p e r i e n c e d a s h a r p i n c r e a s e o r d e c r e a s e i n d e p o s i t s , i t s r e s e r v e s w o u l d a l s o show an i n c r e a s e o r d e c r e a s e . As m e n t i o n e d p r e v i o u s l y i n t h i s c h a p t e r , I w i l l be u s i n g d a t a f o r t h e i n d i v i d u a l C a n a d i a n c o m m e r c i a l b a n k s . Some o f t h e v a r i a b l e s a l r e a d y p r e s e n t e d , s u c h as p e r c e n t a g e A l s o i f a bank a c t s as a f i s c a l a g e n t f o r a s e n i o r l e v e l o f g o v e r n m e n t s u c h as t h e F e d e r a l G o v e r n -ment t h i s may. a f f e c t t h e b a n k s r e s e r v e h o l d i n g s p e r h a p s b e c a u s e o f some g r e a t e r v a r i a b i l i t y o f s u c h g o v e r n m e n t d e p o s i t s . The Bank o f M o n t r e a l was s u c h a f i s c a l a g e n t f o r t h e F e d e r a l G o v e r n -ment f o r most o f t h e p e r i o d u n d e r s t u d y . A c c o u n t must be t a k e n o f t h i s when t e s t i n g t h e m o d e l . 30 o f d e p o s i t s , w h i c h are demand d e p o s i t s and the p e r c e n t a g e w h i c h are i n t e r b a n k d e p o s i t s , . w i l l r e f l e c t d i f f e r e n c e s among i n d i v i d u a l banks . However , one f u r t h e r d i f f e r e n c e s h o u l d be i n c l u d e d . T h i s i s the d i f f e r e n c e i n s i z e among b a n k s . A s i z e v a r i a b l e w i l l be i n c l u d e d t o see i f t h e r e i s any e v i d e n c e o f economies t o s c a l e i n b a n k i n g w i t h r e g a r d s t o t h e h o l d i n g o f r e s e r v e s . That t h e n i s the model b u t b e f o r e a c t u a l l y t e s t i n g i t , i t w i l l be n e c e s s a r y t o i n v e s t i g a t e the concept and measurement o f r e s e r v e r a t i o s . CHAPTER THREE THE CONCEPT A N D MEASUREMENT OF RESERVE RATIOS I n t h i s c h a p t e r I c o n s i d e r some o f t h e c o n c e p t u a l and d a t a p r o b l e m s i n v o l v e d i n c a l c u l a t i n g C a n a d i a n c o m m e r c i a l bank r e s e r v e r a t i o s . The C o n c e p t o f a R e s e r v e R a t i o S i n c e t h e r e was no r e q u i r e d r e s e r v e r a t i o i n Canada 37 p r i o r t o 1 9 3 5 , t h e r e was no o f f i c i a l c o n c e p t o f r e s e r v e s . Such a r e q u i r e m e n t was f i r s t i n t r o d u c e d i n 1 9 3 5 , a f t e r w h i c h banks were r e q u i r e d t o h o l d f i v e p e r c e n t o f t h e i r C a n a d i a n d e p o s i t l i a b i l i t i e s i n t h e form o f v a u l t c a s h o r d e p o s i t s 3 8 w i t h t h e Bank o f C a n a d a . M o s t s t u d i e s o f r e s e r v e b e -h a v i o u r f o c u s on t h e b a n k ' s h o l d i n g s o f e x c e s s r e s e r v e s , t h a t Banks w e r e , h o w e v e r , r e q u i r e d a f t e r 1891 t o make a d e p o s i t ( c o n t r i b u t i o n ) t o t h e Bank C i r c u l a t i o n R e d e m p t i o n Fund and c o u l d a f t e r 1913 make d e -p o s i t s i n t h e C e n t r a l G o l d R e s e r v e . The Bank C i r c u l a t i o n Redempt ion Fund was s e t up t o guarantee , t h e r e d e m p t i o n o f bank n o t e s o f f a i l e d banks and e a c h bank was r e q u i r e d t o c o n t r i b u t e a c c o r d i n g t o a s e t f o r m u l a . The C e n t r a l G o l d R e s e r v e was m e n t i o n e d i n t h e p r o i o u s c h a p t e r , f o o t n o t e 33 # p o r more i n f o r m a t i o n on t h e above c o n s u l t H . P . W i l l i s and B . H . B e c k h a r t , e d . , F o r e i g n B a n k i n g S y s t e m s , New Y o r k , Henry H o l t , p p . 3 8 0 - 8 1 ; 385-87 and R. C r a i g M c l v o r , C a n a d i a n M o n e t a r y , B a n k i n g and  F i s c a l D e v e l o p m e n t , T o r o n t o , M a c m i l l a n , 1 9 5 8 , p p . 77 and 8 4 . Bank o f Canada A c t , 1 9 3 4 , S e c t i o n 27 ( 1 ) . i s r e s e r v e s i n e x c e s s o f r e q u i r e d r e s e r v e h o l d i n g s . S i n c e t h e s e a r e n o t r e l e v a n t c o n c e p t s i n t h e C a n a d i a n ca se b e f o r e 1 9 3 5 , i n t h i s t h e s i s I w i l l e s t i m a t e t h e demand f o r r e s e r v e h o l d i n g s o f t h e banks r a t h e r t h a n " e x c e s s r e s e r v e s " . To do t h i s i t i s n e c e s s a r y t o d e t e r m i n e what e x a c t l y s h o u l d be c o n s i d e r e d as r e s e r v e s . The C o n t e m p o r a r y V i e w What d i d t h e C a n a d i a n b a n k e r h i m s e l f c o n s i d e r as 39 r e s e r v e s ? B . H . B e c k h a r t s t a t e s t h a t t h e C a n a d i a n b a n k e r w o u l d i n c l u d e : c a s h on h a n d , d e p o s i t s w i t h banks i n f o r e i g n c o u n t r i e s , c a l l l o a n s i n New lork and L o n d o n , and S e c u r i t i e s and C o m m e r c i a l p a p e r . A n o t h e r statem<at o f what c o n s t i t u t e s r e s e r v e s appear s i n t h e R e p o r t o f t h e 1933 R o y a l C o m m i s s i o n on B a n k i n g and C u r r e n c y . "The g e n e r a l p r a c t i c e o f t h e C A n a d i a n banks i s t o c l a s s i f y t h e i r r e s e r v e s i n two c a t e g o r i e s : (1) c a s h a s s e t s and (2) q u i c k l y r e a l i z a b l e a s s e t s , a l s o c a l l e d s e c o n d a r y r e s e r v e s . . . T h e " c a s h a s s e t s " i n c l u d e (a) g o l d and s u b -s i d i a r y c o i n , (b) D o m i n i o n n o t e s , (c) U n i t e d S t a t e s and o t h e r f o r e i g n c u r r e n c i e s , (d) n o t e s o f o t h e r b a n k s , (e) cheques on o t h e r b a n k s , ( f ) b a l a n c e s due by banks and b a n k i n g c o r r e s p o n d e n t s e l s e w h e r e t h a n i n C a n a d a , (g) b a l a n c e s due by o t h e r banks i n Canada."^0 W i l l i s and B e c k h a r t , Op. c i t . , p . 4 3 0 . R e p o r t o f t h e R o y a l C o m m i s s i o n on B a n k i n g and C u r r e n c y  i n C a n a d a , O t t a w a , K i n g s P r i n t e r , 1933 , p . 3 2 . 33 I t w o u l d seem t h a t t h e r e was no agreement as to what a s s e t s c o n s t i t u t e r e s e r v e s . I t w i l l be n e c e s s a r y t o d e f i n e what we mean by r e s e r v e s and t h e n by l o o k i n g at the b a n k s ' b a l a n c e s s h e e t s d e t e r m i n e w h i c h a s s e t s w i l l be c o n s i d e r e d as r e s e r v e s . D e f i n i t i o n o f Reserves f rom Economic Theory In the p r e v i o u s c h a p t e r we l o o k e d at why banks h e l d r e s e r v e s . But what e x a c t l y are r e s e r v e s ? . The u l t i m a t e t e s t o f w h e t h e r an a s s e t can be i n c l u d e d i n r e s e r v e s i s i t l i q u i d -i t y . " S i n c e the purpose o f r e s e r v e s i s to be a v a i l a b l e to meet any u n f o r e s e e n w i t h d r a w a l s they, must be i n a form r e a d i l y a c c e p t a b l e t o . b a n k d e p o s i t o r s o r e a s i l y c o n v e r t e d i n t o such a form i n a s h o r t t i m e p e r i o d and w i t h l i t t l e o r no r i s k o f c a p i t a l , l o s s . W i t h i n the c a t e g o r y o f r e s e r v e s we have some a s s e t s more l i q u i d t h a n o t h e r s , s t a r t i n g at one end o f a s p e c t r u m w i t h cash r e s e r v e s and a d v a n c i n g a l o n g t o o t h e r a s s e t s w h i c h are f a i r l y l i q u i d but may perhaps e a r n some i n t e r e s t . As we move a l o n g the s p e c t r u m away, f rom cash r e s e r v e s i n t o s e c o n d a r y r e s e r v e s the l i q u i d i t y becomes l e s s and the i n t e r e s t r e t u r n g r e a t e r : . At some p o i n t the a s s e t s s t o p b e i n g c o n s i d e r e d as p a r t o f r e s e r v e s and are c o n s i d e r e d as p a r t o f the banks' s e c u r i t i e s p o r t f o l i o . In t h i s t h e s i s I 41 w i l l o n l y be cons ider ing cash r e s e r v e s - - t h a t i s , the most l i q u i d end o f the r e s e r v e " spec t rum. T h i s i s p a r t l y j u s t a What e x a c t l y i s i n c l u d e d i n cash r e s e r v e s w i l l be shown i n the n e x t s e c t i o n . 34 m a t t e r o f c h o i c e as t o where e x a c t l y t o draw t h e l i n e . A l s o s e c o n d a r y r e s e r v e s were n o t i n c l u d e d because o f c e r t a i n f e a t u r e s t h e y had d u r i n g t h i s t i m e p e r i o d i n C a n a d a . S e c o n d a r y r e s e r v e s a r e t h o s e a s s e t s w h i c h do e a r n some i n t e r e s t b u t y e t s t i l l c an be c o n v e r t e d i n t o c a s h r e s e r v e s w i t h l i t t l e c o s t o r r i s h o f l o s s . I n o r d e r f o r s o - c a l l e d s e c o n d a r y r e s e r v e a s s e t s t o a c t u a l l y be c o n s i d e r e d as p a r t o f r e s e r v e s i t i s n e c e s s a r y that t h e r e b e , i n t h e case o f s e c u r i t i e s , a w e l l - e s t a b l i s h e d m a r k e t f o r s u c h a s s e t s i n o r d e r t h a t t h e y may be q u i c k l y s o l d w i t h l i t t l e c o s t i n v o l v e d i n making t h e a c t u a l s a l e . A l s o t h i s m a r k e t i s n e c e s s a r y i n o r d e r t o l e s s e n t h e r i s k o f c a p i t a l l o s s when h a v i n g t o d i s p o s e o f s u c h a s s e t s b e f o r e m a t u r i t y . Thus any C a n a d i a n . s h o r t t e r m s e c u r i t i e s w o u l d have t o be e x c l u d e d because t h e r e was no e s t a b l i s h e d m a r k e t f o r them a t t h i s t i m e . What a b o u t f o r e i g n s h o r t t e r m s e c u r i t i e s ? There was an e s t a b l i s h e d m a r k e t f o r them i n New Y o r k and t h u s t h e a c t u a l c o s t o f c a r r y i n g o u t b u y i n g and s e l l i n g o p e r a t i o n s w o u l d be low b u t t h e i r l i q u i d i t y was i m p a i r e d by t h e r i s k o f a f u t u r e a d v e r s e movement o f t h e f o r e i g n exchange r a t e . A n o t h e r t y p i c a l a s s e t i n c l u d e d as s e c o n d a r y r e s e r v e s i s c a l l l o a n s . C a l l l o a n s i n CAnada a t t h i s t i m e however were n o t s u b j e c t t o i m m e d i a t e c a l l as t h e y a r e nowadays . C a l l l o a n s i n New Y o r k were s u b j e c t t o c a l l b u t a g a i n t h e i r l i q u i d i t y was i m p a i r e d by t h e r i s h o f a f u t u r e a d v e r s e movement o f t h e f o r e i g n exchange r a t e . I n t h i s t h e s i s I w i l l be c o n s i d e r i n g as r e s e r v e s o n l y c a s h r e s e r v e s . 35 The Banks' B a l a n c e Sheet Which o f the C a n a d i a n c o m m e r c i a l banks ' a s s e t s c o u l d be i n c l u d e d i n cash r e s e r v e s ? " G o l d and s u b s i d i a r y c o i n " and " D o m i n i o n n o t e s " are the most l i q u i d o f the banks' a s s e t s s i n c e t h e y are r e a d i l y a c c e p t a b l e i n t h e i r p r e s e n t form by any o f the banks d e p o s i t o r s . " N o t e s o f o t h e r b a n k s " , "cheques on o t h e r b a n k s " and " d e p o s i t s w i t h o t h e r C a n a d i a n b a n k s " w^ere a l s o e x t r e m e l y l i q u i d because "tey can be c o n v e r t e d i n t o g o l d o r Domin ion n o t e s s i m p l y by making p r e s e n t a t i o n at the o t h e r bank o r banks i n v o l v e d o r i n the case o f n o t e s o f o t h e r b a n k s , used d i r e c t l y t o meet w i t h d r a w a l s i f n e c e s s a r y . The t h r e e p r e c e d i n g t y p e s o f a s s e t s a re i n c l u d e d i n ca sh r e s e r v e s be-cause I am c a l c u l a t i n g the r e s e r v e r a t i o s o f each i n d i v i d u a l b a n k . I f the r e s e r v e r a t i o o f the whole b a n k i n g sys tem i s c a l c u l a t e d the above t h r e e f a c t o r s w o u l d no t be i n c l u d e d s i n c e t h e s e i t e m s are a s s e t s o f one bank i n the sys tem w h i l e b e i n g l i a b i l i t i e s o f a n o t h e r and thus would c a n c e l out when a r e s e r v e r a t i o was c a l c u l a t e d f o r the s y s t e m . A n o t h e r ex-t r e m e l y l i q u i d a s s e t i s "Government and bank n o t e s o t h e r t h a n C a n a d i a n " , s i n c e t h e s e can be used t o p u r c h a s e g o l d a n d / o r D o m i n i o n n o t e s f rom o t h e r Canadian o r f o r e i g n banks v e r y q u i c k l y and w i t h l i t t l e o r no l o s s . " D e p o s i t s w i t h and sums, due f rom f o r e i g n banks and b a n k i n g c o r r e s p o n d e n t s " , are a l s o f a i r l y l i q u i d s i n c e t h e y can be t r a n s f e r r e d w i t h i n a s h o r t 36 time to meet any deposit withdrawals. "Deposits with] the Bank of Canada" (after 1935) constitute part of the o f f i c i a l d e f i n i t i o n of reserves and so they are included also. "Dep-o s i t s i n the Central Gold Reserve", are a border l i n e case. Canadian commercial banks had the p r i v i l e g e up u n t i l 1935 (when i t began to be curtailed) of issuing t h e i r own bank notes. Any note issue beyond an amount equal to the issuing banks paid up c a p i t a l had to be matched by a d e p o s i t i n the Central Gold Reserve. Ideally only "free" Central Gold Reserve Deposits ( i . e . , Deposits i n excess of reserves against covered bank note c i r c u l a t i o n ) should be included i n reserves against deposits, but monthly data on such deposits are not available on an i n d i v i d u a l bank basis. Also i f , as I do i n t h i s study, one includes notes i n c i r -culation as a l i a b i l i t y of the bank against which i t must hold reserves, then i t i s legitimate to include deposits i n the Central Gold REserve i n reserves. We have now looked at what could be included i n cash reserves but there i s also the problem of what could be included i n the denominator of a reserve r a t i o . In other words, against what are the reserves being held? Again u n t i l 1935, when i t became Canadian deposit l i a b i l i t i e s , there was no o f f i c i a l d e f i n i t i o n . One possible d e f i n i t i o n could be a l l deposit l i a b i l i t i e s of the bank. Other possible d e f i n i t i o n s involve varying combinations of Canadian deposit l i a b i l i t i e s , ce f o r e i g n d e p o s i t l i a b i l i t i e s and n o t e s i n c i r c u l a t i o n . The above t h e n a r e p o s s i b l e i t e m s w h i c h c o u l d be i n c l u d e d when c a l c u l a t i n g a r e s e r v e r a t i o . Because o f t h e l a c k o f any c l e a r c u t d e f i n i t i o n i t w i l l be n e c e s s a r y t o c a l c u l a t e s e v e r a l r e s e r v e r a t i o s by v a r y i n g t h e i t e m s i n c l u d e d i n t h e n u m e r a t o r and d e n o m i n a t o r . T a b l e I b e l o w g i v e s a l l t h e p o s s i b l e " c a s h " a n d " d e p o s i t and n o t e " i t e m s t o be i n c l u d e d . TABLE ONE RESERVE ASSETS 1. G o l d and s u b s i d i a r y c o i n 2 . D o m i n i o n n o t e s ( a f t e r 1935 n o t e s o f t h e Bank o f Canada) 3 . N o t e s o f o t h e r banks 4 . Cheques on o t h e r banks 5 . D e p o s i t s made w i t h and b a l a n c e s due f rom t h e o t h e r banks i n C a n a d a . 6 . Due f r o m banks and b a n k i n g c o r r e s p o n d e n t s i n t h e U n i t e d Kingdom 7 . Due f r o m banks and b a n k i n g c o r r e s p o n d e n t s e l s e w h e r e t h a n i n Canada and t h e U n i t e d Kingdom 8. D e p o s i t s w i t h t h e Bank o f Canada ( a f t e r 1935) 9 . Government and Bank n o t e s o t h e r t h a n C a n a d i a n ( a l s o c a l l e d U . S . and o t h e r f o r e i g n c u r r e n c i e s ) 1 0 . D e p o s i t s i n t h e C E n t r a l G o l d R e s e r v e . 38 L I A B I L I T I E S 10 . B a l a n c e s due t o Domin ion Government a f t e r d e d u c t i n g advances f o r c r e d i t , p a y - l i s t s , e t c . , 1 1 . B a l a n c e s due to P r o v i n c i a l Governments 12 . D e p o s i t s by the p u b l i c p a y a b l e on demand i n Canada 1 3 . D e p o s i t s by the p u b l i c p a y a b l e a f t e r . n o t i c e o r on a f i x e d day i n Canada 14. D e p o s i t s e l s e w h e r e t h a n i n Canada 15 . D e p o s i t s made by and b a l a n c e s due t o o t h e r banks i n Canada 16. Due to banks and b a n k i n g c o r r e s p o n d e n t s i n the U n i t e d Kingdom 1 7 . Due t o banks and b a n k i n g c o r r e s p o n d e n t s e l s e w h e r e t h a n i n Canada and the U n i t e d Kingdom l g . Notes i n c i r c u l a t i o n The Reserve R a t i o s What w i l l be i n c l u d e d i n the r a t i o s to be c a l c u -l a t e d ? The numbers a p p e a r i n g be low are t h o s e r e p r e s e n t i n g the d i f f e r e n t t y p e s o f a s s e t s and l i a b i l i t i e s i n T a b l e One. 1 + 2 + 3 + 4 :+: 5 + 6 7 + 8 j 9 + 18 A . Comprehens ive R a t i o : 10 +11 +12 +13 +14+ 15+ 16 + 17+19 1 + 2 + 3 + 4 + 5 + 8 + 1 8 10 + 1 1 + 12 + 13 + 15 + 19 C. F o r e i g n R a t i o B. D o m e s t i c R a t i o 6 + 7 •+, 9 14 + 16 + 17 39 D. Cash R a t i o ( i n c l u d i n g n o t e s : : 1 + 2 + 5' '.'+" 8 + 9 as l i a b i l i t i e s ) 10 + 11 + 12 + .'13'"' + 15 •+' 19 E . Cash R a t i o ( e x c l u d i n g n o t e s : 1 +'. 2 + 3 "+" 8 + 9 as l i a b i l i t i e s ) 10 + 11 + 12 + .15.' + 15 F . S i m i l a r t o 1 + 2 + 3 + 4 + 5 + 7 + 8 M o r r i s o n ' s R a t i o : 10 + 11 + ,12''.+ 13 + 1 4 + 1 6 + 17 G. R a t i o s f o r the b a n k i n g sys tem as a whole are s i m i l a r t o the above e x c e p t t h a t 3 , 4 , and 5 are dropped from the n u m e r a t o r w h e r e v e r t h e y appear and 15 i s dropped from the d e n o m i n a t o r w h e r e v e r i t a p p e a r s . The Comprehens ive R a t i o i s s i m p l y the sum o f a l l the a s s e t s I have d e f i n e d as cash r e s e r v e s o v e r the sum o f a l l the d e p o s i t and n o t e l i a b i l i t i e s f o r each b a n k . The Domes t i c R a t i o as i t i m p l i e s i s l i m i t e d t o d o m e s t i c a s s e t s and l i a b i l i t i e s and s i m i l a r l y f o r the F o r e i g n R a t i o . Then t h e r e are the two Cash R a t i o s i n c l u d i n g and e x c l u d i n g n o t e s as l i a b i l i t i e s . These two r a t i o s i n c l u d e o n l y the most l i q u i d o f cash r e -s e r v e s i n the n u m e r a t o r and o n l y C a n a d i a n d e p o s i t l i a b i l i t i e s (as w e l l as n o t e s i n c i r c u l a t i o n i n the one i n s t a n c e ) i n the d e n o m i n a t o r . A l s o t h e r e i s a r a t i o s i m i l a r to the one c a l -42 c u l a t e d by George M o r r i s o n when he d e t e r m i n e d t h a t the Can-a d i a n b a n k i n g sys tem adhered f a i r l y c l o s e l y to a t e n p e r c e n t 4 2 - George M o r r i s o n , L i q u i d i t y P r e f e r e n c e s o f Commerc i a l Banks , U n i v e r s i t y o f Chcago P r e s s , C h i c a g o , 1966, p . 7 0 - 7 1 . 40 r e s e r v e . I t i s o n l y s i m i l a r and n o t e x a c t l y the same because M o r r i s o n was l o o k i n g at t h e sy s tem as a whole and I am l o o k i n g at each i n d i v i d u a l bank . A l s o , M o r r -i s o n i n c l u d e s i n r e s e r v e s f r e e C e n t r a l G o l d Reserve D e p o s i t s , bu t as m e n t i o n e d p r e v i o u s l y , the se f i g u r e s are no t a v a i l a b l e f o r each bank by month and the t a s k o f c a l c u l a t i n g them would be p r o d i g i o u s . T h e r e f o r e , I have assumed t h a t t h e y w i l l be s m a l l . I a l s o c a l c u l a t e a l l the above r a t i o s f o r the C a n a d i a n b a n k i n g sys tem as a w h o l e . The o n l y d i f f e r e n c e between the r a t i o s f o r the sy s tem and those f o r the i n d i v i d u a l banks i s a d r o p p i n g o f a l l C a n a d i a n i n t e r b a n k a s s e t s and l i a b i l i t i e s f o r the r e a s o n g i v e n p r e v i o u s l y . Source and l i m i t a t i o n s o f the d a t a The data : t o c a l c u l a t e , the r e s e r v e r a t i o s appears i n the o f f i c i a l m o n t h l y r e t u r n s o f the c o m m e r c i a l banks t o the M i n i s t e r o f F i n a n c e w h i c h are p u b l i s h e d as supp lements • 43 t o the Canada G a z e t t e . The ma jor l i m i t a t i o n o f the data , i s t h e f a c t t h a t t h e y are month"end f i g u r e s r a t h e r t h a n m o n t h l y a v e r a g e s . That i s , the f i g u r e s r e p r e s e n t t h e s i t u a t i o n on the l a s t day o f each month r a t h e r t h a n the average o f each day o f Canada G a z e t t e , 1920 - 19 39 , K i n g s P r i n t e r , O t t a w a . 41 t h e month . T h i s p r a c t i c e p r o b a b l y r e s u l t s i n the c o m m e r c i a l banks e n g a g i n g i n window d r e s s i n g . G e n e r a l l y t h i s i s an a t t empt by banks t o make t h e i r s i z e a n d / o r f i n a n c i a l p o s i t i o n appear b i g g e r and b e t t e r t h a n i t i s . T h i s may be used t o i n f l u e n c e the p u b l i c i n f a v o u r o f p a t r o n i z i n g the bank i n q u e s t i o n a n d / o r to c o n v i n c e the F i n a n c e Department o f the s o l v e n c y o f the b a n k . For e x a m p l e , t h e r e i s o f t e n some doubt as to the a c t u a l v a l u e of. some o f a banks a s s e t s and the bank w i l l p l a c e a h i g h e r v a l u e on t h a t a s s e t t h a n may be j u s t i f i e d . A l s o , the banks may a r r a n g e t h e i r p o r t f o l i o s i n a c e r t a i n way on the day t h e - r e t u r n i s f i l e d and t h e n f o l l o w a c o m p l e t e l y d i f f e r e n t p o l i c y on the r e m a i n i n g days o f the month. The banks own a c t i o n a s i d e , economic c o n d i t i o n s w h i c h i n f l u e n c e r e s e r v e h o l d i n g s may on the day the r e t u r n s are f i l e d be v e r y d i f f e r e n t f rom c o n d i t i o n s p r e v a l e n t t h r o u g h o u t the r e s t o f the month . Thus one may get a v e r y d i s t o r t e d p i c t u r e s i n c e the l a s t day o f the month f i g u r e s may be v e r y d i f f e r e n t from the average c o n d i t i o n s d u r i n g t h e month . What e f f e c t wou ld the above l i m i t a t i o n s have on the data? I f window d r e s s i n g i s i n d e e d i m p o r t a n t t h i s w o u l d b i a s the r e s u l t s i n f a v o u r , o f g r e a t e r l i q u i d i t y t h a n 42 a c t u a l l y e x i s t e d ( s i n c e a b a n k ' s ma in w o r r y i s t o c o n -v i n c e t h e p u b l i c t h a t i t i s s o l v e n t i t w o u l d most p r o b -a b l y window d r e s s i n f a v o u r o f g r e a t e r l i q u i d i t y ) . T h i s w o u l d p r o d u c e h i g h e r r e s e r v e r a t i o s t h a n a c t u a l l y e x i s t e d : I w i l l have t o assume t h a t window d r e s s i n g i s s m a l l . The most p r o b a b l e a s s u m p t i o n a b o u t t h e e c o n o m i c c o n d i t i o n s a f f e c t i n g t h e h o l d i n g o f r e s e r v e s mustbe -that t h e y a r e random and t h u s t h a t t h e a c t u a l s i t u a t i o n on t h e l a s t day o f e ach month w i l l d i f f e r r a n d o m l y f r o m t h e average c o n d i t i o n s 2 o f t h e m o n t h . T h i s w i l l cause a r e d u c t i o n xn R Qfr i t i s 44 t o be h o p e d , n o t t o o g r e a t an e x t e n t . The above d a t a l i m i t a t i o n s s h o u l d be k e p t i n mind when i n t e r p r e t i n g t h e r e s u l t s l a t e r i n t h i s t h e s i s . I f we assume t h a t t h e e c o n o m i c c o n d i t i o n s w h i c h a f f e c t t h e h o l d i n g o f r e s e r v e s a r e random and o p e r a t e s u c h as t o cause t h e d a i l y a c t u a l h o l d i n g o f r e s e r v e s t o be norma d i s t r i b u t e d i n a g i v e n month t h e n i f m o n t h l y average f i g u r e s were u s e d t h e o b s e r v a t i o n s w o u l d c l u s t e r a r o u n d a l i n e f i t t e d t o t h e d a t a w h i l e i f d a t a f r o m t i i e l a s t day o f t h e month i s u s e d t h e s e o b s e r v a t i o n s may be anywhere i n t h e n o r m a l d i s t r i b u t i o n f o r e a c h month and t h u s t h e s e o b s e r v a t i o n s w o u l d n o t l i e as c l c e t o a l i n e f i t t e d t o them as t h e m o n t h l y average o b s e r v a t i o n s d i d t o £he l i n e f i t t e d t o them. T h i s r e s u l t s i n a l o w e r R . CHAPTER FOUR THE RESERVE. RATIOS: OBSERVATIONS AND CONCLUSIONS I n t r o d u c t i o n The r e s u l t s from c a l c u l a t i n g the r e s e r v e r a t i o s w h i c h were p r e s e n t e d i n the l a s t c h a p t e r w i l l be a n a l y z e d h e r e aid some c o n c l u s i o n s drawn w h i c h a re p e r t i n e n t t o t h i s t h e s i s . As w e l l as r e f u t i n g the h y p o t h e s i s of a t e n p e r c e n t r e s e r v e r e q u i r e m e n t b e i n g adhered t o i n Canada , some o t h e r i n t e r e s t i n g f i n d i n g s a re p r e s e n t e d . The : R a t i o s Of. the s i x r a t i o s c a l c u l a t e d , f i v e o f them, Ratios A , B , D, E , and F can be r e p r e s e n t e d by j u s t the two R a t i o s A and E s i n c e the o t h e r s f o l l o w c l o s e l y movements i n e i t h e r o f the se t w o . R a t i o C ( the F o r e i g n R a t i o ) e x h i b i t e d t r e m -endous swings and was o f such a magni tude t h a t ' i t was c l e a r l y n o t the r e s e r v e r a t i o I s o u g h t . R a t i o s A and E , -graphed f o r each b a n k , appear i n the A p p e n d i x . R a t i o s A , B , D, aid E a r e g i v e n f o r the Bank o f M o n t r e a l and M o l s o n ' s Bank to show how movements i n the r a t i o s do f o l l o w e i t h e r R a t i o A or E . Of the two r a t i o s , A and E , the Cash R a t i o ( E ) , seems t o be 44 the one w h i c h p e o p l e meant when t h e y t a l k e d o f C a n a d i a n banks h o l d i n g t e n per c e n t r e s e r v e s , s i n c e i t comes c l o s e s t t o . t h i s , t e n per cent l e v e l . T h e r e f o r e , t h e f o l l o w i n g o b s e r -v a t i o n s w i l l be on t h i s Cash R a t i o ( E ) . A n n u a l Peaks The f i r s t t h i n g t o n o t i c e i s the o c c u r e n c e o f r e g u l a r a n n u a l peaks i n the r e s e r v e r a t i o s o f most o f the b a n k s . The s i z e o f t h e s e peaks and the month i n w h i c h t h e y o c c u r d i f f e r among banks and t h e y c o i n c i d e e x a c t l y w i t h the 45 . y e a r end o f each bank . . T h u s , the banks do i n d u l g e i n window d r e s s i n g w i t h r e g a r d s t o t h e i r own a n n u a l r e p o r t s . That i s , on the month w h i c h happens t o be t h e i r y e a r e n d , most banks i n c r e a s e t h e i r h o l d i n g s o f cash r e s e r v e s i n o r d e r t o c o n v i n c e the p u b l i c , and i n p a r t i c u l a r the s h a r e -h o l d e r s , o f t h e i r l i q u i d i t y . In C h a p t e r T h r e e , w h i l e d i s c u s s i n g the p r o b l e m o f u s i n g month end d a t a , i t was m e n t i o n e d t h a t banks may window d r e s s the month end f i g u r e s by i n c r e a s i n g the amount o f ca sh r e s e r v e s t h e y h e l d on t h e l a s t . d a y o f each month and t h e n h o l d i n g l e s s f o r the r e s t o f the month . The e v i d e n c e o f window d r e s s i n g w i t h r e g a r d s t o the a n n u a l r e p o r t s thus r e i n f o r c e s the c a u t i o n ment ioned 45 A c c o u n t w i l l have t o be t a k e n o f t h i s when t h e model i s , t e s t e d . 45 i n C h a p t e r Three o f the p o s s i b l e b i a s upwards i n t h e r e s u l t s . V a r i a t i o n i n the Reserve R a t i o s o f I n d i v i d u a l Banks These peaks a s i d e there i s s t i l l c o n s i d e r a b l e v a r i a t i o n i n the r e s e r v e r a t i o o f each b a n k . P a r t o f t h i s v a r i a t i o n , i t must be remembered i s a r e s u l t o f the 46 use o f month end f i g u r e s r a t h e r t h a n m o n t h l y a v e r a g e s . The r e m a i n d e r o f the v a r i a t i o n i s a r e s u l t o f the bank a l t e r i n g i t s r e s e r v e h o l d i n g s i n r e s p o n s e t o changes i n c e r t a i n v a r i a b l e s . H o p e f u l l y , t h i s w i l l be e x p l a i n e d by t h e m o d e l . D i f f e r e n c e s Among Banks There i s a l s o a marked d i f f e r e n c e among banks as t o the amount o f r e s e r v e s t h e y h o l d as shown by t h e mean o f Cash R a t i o E f o r each bank g i v e n i n T a b l e I I . S u r p r i s i n g l y i t seems t h a t the l a r g e r banks h e l d g r e a t e r cash r e s e r v e s t h a n the s m a l l e r b a n k s . L o o k i n g o n l y a t the banks w h i c h e x i s t e d t h r o u g h o u t the whole p e r i o d , (see A p p e n d i x ) two o f the t h r e e l a r g e s t b a n k s , the Bank 46 44 See f o o t n o t e 46 o f M o n t r e a l and the R o y a l Bank o f Canada , se ldom went be low t e n per cen t r e s e r v e s w h i l e the t h i r d , the C a n a d i a n Bank o f Commerce, se ldom went be low e i g h t p e r c e n t . On t h e o t h e r hand the s m a l l e s t bank w h i c h e x i s t e d t h r o u g h o u t t h i s whole p e r i o d , the Banque P r o v i n c i a l e du Canada h e l d a round t h r e e p e r . c e n t r e s e r v e s b e f o r e M a r c h , 1935 . M i d d l e -s i z e d banks h e l d r e s e r v e s between t h e s e e x t r e m e s . L o o k i n g at banks w h i c h d i d no t e x i s t t h r o u g h the whole p e r i o d ( g e n e r a l l y much s m a l l e r banks) we f i n d some even lower h o l d i n g s o f r e s e r v e s . The Weyburn S e c u r i t y Bank f o r example h e l d o n l y two p e r c e n t ca sh r e s e r v e s f o r a w h i l e . D e c l i n e i n Reserves over Time O b s e r v i n g a l l o f the banks d u r i n g t h i s p e r i o d we f i n d a d e c l i n e i n r e s e r v e h o l d i n g s o v e r t i m e , c o n t i n u i n g , f o r some banks u n t i l 1929-30 and f o r o t h e r s u n t i l M a r c h , 1935. The S t a n d a r d Bank h e l d t w e l v e p e r cen t u n t i l the b e g i n n i n g o f 1922, t h e n t e n p e r cen t u n t i l the b e g i n n i n g o f 1925, seven per c e n t u n t i l the m i d d l e o f 1926 and f i n a l l y s i x per cen t 47 u n t i l the c e a s i n g o f o p e r a t i o n s m O c t o b e r , 1928 . The Remember t h a t when I speak o f the banks h o l d i n g s i x or seven p e r c e n t , I mean d i s r e g a r d i n g the a n n u a l peaks and the o s c i l l a t i o n s w h i c h are c o n s i d e r a b l e f o r some b a n k s . TABLE I I MEAN OF THE CASH RATIO (E) FOR EACH BANK BANK MEAN (%) Bank o f M o n t r e a l 1 5 . 4 7 -Bank o f Nova S c o t i a . . . . . . . . 14 .43 Bank o f T o r o n t o 9 .67 M o l s o n ' s Bank. . . . . . . 7 .99 Banque N a t i o n a l e 6 .20 M e r c a n t i l e Bank . . . .." . . . " . 7 .61 Banque P r o v i n c i a l e 5 .08 U n i o n Bank . . . . . . . . . . . . 10 .36 C a n a d i a n Bank o f Commerce. 10 .20 R o y a l Bank o f Canada . 15 .95 Domin ion Bank 9 .25 Bank o f H a m i l t o n 8.69 S t a n d a r d Bank . 9 .48 B a n q u e ' C a n a d i e n n e N a t i o n a l e ( f o r m e r l y Banque d ' H o c h e l a g a ) . . . . 6 .31 I m p e r i a l Bank o f Canada . 88 .82 Home Bank 10 .67 S t e r l i n g Bank'. 7 .84 Weyburn Bank . . [ . } • 4 .37 B a r c l a y ' s Bank \ . 8 .31 48 D o m i n i o n Bank h e l d t e n p e r cen t u n t i l the m i d d l e o f 1925, t h e n n i n e p e r cen t u n t i l the e n d . of 1928, seven p e r cen t u n t i l the end o f 1929, and s i x p e r c e n t u n t i l M a r c h , 1935. E f f e c t o f the D e p r e s s i o n The above downward t r e n d i n r e s e r v e s b e g a n , f o r some b a n k s , t o t u r n up w i t h t h e b e g i n n i n g o f the G r e a t D e p r e s s i o n . T h i s r i s e i n r e s e r v e h o l d i n g s o f C a n a d i a n banks as a r e s u l t o f the D e p r e s s i o n i s i n c o n t r a s t t o 48 M o r r i s o n ' s f i n d i n g s o f a l m o s t c o n s t a n t t e n p e r cen t r e s e r v e h o l d i n g s . T h u s , t h i s throws some doubt on h i s use o f t h i s f i n d i n g . . / ' t o p r o v e t h a t i t was bank f a i l u r e s t h a t caused A m e r i c a n banks t o i n c r e a s e t h e i r h o l d i n g s o f 49 r e s e r v e s . The r i s e i n r e s e r v e h o l d i n g s o f C a n a d i a n b a n k s , perhaps i s e x p l a i n e d by a f a l l i n i n t e r e s t r a t e s . Even s o , as l o n g as r e s e r v e s d i d r i s e , t h i s s t i l l damages M o r r i s o n ' s argument because i n t e r e s t r a t e s were low i n b o t h Canada and the U . S . A . T h u s , perhaps the low i n t e r e s t r a t e s a l s o e x p l a i n the i n c r e a s e d r e s e r v e h o l d i n g s o f George M o r r i s o n , L i q u i d i t y P r e f e r e n c e s o f C o m m e r c i a l B a n k s , C h i c a g o , U n i v e r s i t y of C h i c a g o P r e s s , 1966. 49 H i s r e a s o n i n g was t h a t i f i t was bank f a i l u r e s w h i c h caused banks t o i n c r e a s e r e s e r v e s then t h e r e should be no i n c r e a s e i n r e s e r v e s by C a n a d i a n banks because t h e r e were no bank f a i l u r e s d u r i n g the G r e a t De-p r e s s i o n . 49 American banks. No, says Morrison, because i n t e r e s t rates f e l l i n both countries while reserve holdings increased i n the U.S.A. but remained the same i n Canada (according to Morrison's evidence). Thus, Morrison says there must be some other reason for the increased reserve holdings i n the U.S.A., the shock e f f e c t of bank f a i l u r e s . E f f e c t of the Establishment of the Bank of CAnada Why did the reserve holdings of some banks turn up, and rather sharply i n some cases, a f t e r March, 1935? This was the date of the establishment of the Bank of Canada at which time required reserves were i n s t i t u t e d and t h i s had a tremendous e f f e c t on most banks. For those banks which were holding very small amounts of reserves there was a marked increased i n reserve holdings and a l l banks began to hold closer to ten per cent reserves (even though the required reserve was only f i v e per cent), than they had before. For example, the Banque Provinciale which had o s c i l l a t e d around three per cent suddenly jumped to ten per cent aft e r the establishment of the Bank of Canada. S i m i l a r l y the Imperial Bank moved from f i v e per cent 'to eight per cent aft e r March, 1935. 50 C o n c l u s i o n s The e v i d e n c e p r e s e n t e d d i s p r o v e s the h y p o t h e s i s o f t e n p e r c e n t r e s e r v e s b e i n g m a i n t a i n e d by the C a n a d i a n banks because the r e s e r v e s v a r y o v e r t ime and a l s o between b a n k s . A l t h o u g h p r e v i o u s l y i n t h i s c h a p t e r I found e v i d e n c e o f window d r e s s i n g by the b a n k s , i t i s p r o b a b l y s a f e t o assume t h a t a l l banks would window d r e s s t o some e x t e n t and t h a t even i f some d i d so more t h a n o t h e r s the g r e a t d i f f e r e n c e among banks as t o t h e i r h o l d i n g s o f cash r e s e r v e s c o u l d no t be e x p l a i n e d by d i f f e r e n c e s i n window d r e s s i n g a l o n e . I t i s easy enough t o see why such a b e l i e f , as t h e t e i i per c e n t r e s e r v e s b e i n g h e l d , w o u l d p r e v a i l . In a l l p r e v i o u s s t u d i e s i t was c o n c l u d e d t h a t C a n a d i a n banks h e l d t e n p e r cen t r e s e r v e s by u s i n g a n n u a l d a t a f o r t h e whole C a n a d i a n b a n k i n g s y s t e m . The g r e a t e r c o n s t a n c y and a t a l e v e l c l o s e r t o t e n p e r cen t o f the sy s tem r a t i o com-p a r e d f o any i n d i v i d u a l bank can be o b s e r v e d from the g r a p h s . I f , i n a d d i t i o n , the r a t i o was a g g r e g a t e d over t i m e ( a n n u a l averages were used) I am sure i t would show even g r e a t e r c o n s t a n c y . O r , i f the banks r e s e r v e r a t i o s were c a l c u l a t e d from each banks a n n u a l r e p o r t , ' a g a i n you w i l l get r e s u l t s much c l o s e r t o t e n p e r c e n t because o f the banks t e n d e n c y t o window d r e s s d u r i n g the month o f t h e i r y e a r - e n d . 51 There i s a l s o some e v i d e n c e t h a t C a n a d i a n banks i n c r e a s e d t h e i r h o l d i n g o f r e s e r v e s d u r i n g the Grea t D e p r e s s i o n . T h i s throws some doubt on M o r r i s o n ' s r e s u l t s as e x p l a i n e d p r e v i o u s l y . F i n a l l y , the b e l i e f t h a t the e s t a b l i s h m e n t o f the Bank o f Canada had l i t t l e e f f e c t on the r e s e r v e h o l d i n g s o f C a n a d i a n c o m m e r c i a l banks was a l s o r e f u t e d . We w i l l p r o c e e d now t o e x p l a i n by the model p r e -s e n t e d i n C h a p t e r Two, the changes i n r e s e r v e s and the ' " * t d i f f e r e n c e s among banks as t o r e s e r v e h o l d i n g s . CHAPTER FIVE THE TESTING OF THE MODEL I n t r o d u c t i o n The model o f bank cash r e s e r v e b e h a v i o u r p r e s e n t e d i n C h a p t e r Two i s h e r e t e s t e d by m u l t i p l e r e g r e s s i o n a n a l y s i s u s i n g m o n t h l y d a t a f o r the i n d i v i d u a l banks and t h e n m o n t h l y d a t a f o r t h e C a n a d i a n b a n k i n g s y s t e m . Some o b s e r v a t i o n s are made on the r e g r e s s i o n r e s u l t s and i t i s c o n c l u d e d t h a t the model works f a i r l y w e l l when t e s t e d f o r t h e C a n a d i a n b a n k i n g sys tem b u t t h a t f o r t h e i n d i v i d u a l banks the r e s u l t s a re n o t n e a r l y as good . The Model I w i l l r e p e a t h e r e the model t o be t e s t e d t h a t was f i r s t p r e s e n t e d i n C h a p t e r Two. where p = f ( n , r , Y ,.0, C , h , I , G, S) p i s the cash r e s e r v e r a t i o ( R a t i o E ) . n i s the r a t e o f i n t e r e s t on b o r r o w i n g under the F i n a n c e A c t . r j i s the New York c a l l l o a n r a t e . Y i s i m p o r t s . 0 i s the i n t e r e s t , r a t e on l o n g t e rm O n t a r i o Government bonds (as an i n d e x n u m b e r ) . 53 i s r a i l r o a d c a r l o a d i n g s . i s a r a t i o o f demand t o t o t a l d e p o s i t s , i s a r a t i o of i n t e r b m k to t o t a l d e p o s i t s . i s a r a t i o o f t h i s months d e p o s i t s t o l a s t , i s a bank s i z e v a r i a b l e ( t o t a l d e p o s i t s ) . dummy v a r i a b l e s were i n c l u d e d . i s a d u m m y • v a r i a b l e t o t a k e a c c o u n t o f t h e Bank o f M o n t r e a l a c t i n g as f i s c a l agent f o r the F e d e r a l Government . = 1 from J a n u a r y , 1920 to F e b r u a r y , 1935 f o r the Bank o f M o n t r e a l . = 0 e I s e w h e r e . i s a dummy v a r i a b l e t o t a k e a c c o u n t o f the i n c r e a s e i n cash r e s e r v e s because o f window d r e s s i n g i n the banks a n n u a l r e p o r t . = 1 i n the month w h i c h i s y e a r - e n d . = 0 e I s ewhere . i s a dummy v a r i a b l e t o t a k e a c c o u n t o f the s h i f t u p . i n r e s e r v e h o l d i n g s w i t h the e s t a b -l i s h m e n t , o f the Bank o f Canada i n M a r c h , 1935 = 1 f o r each month f o r each bank a f t e r M a r c h , 19 3 5 . = 0 e I s ewhere . . 54 • T h i s model was t h e n t e s t e d u s i n g t h e Cash R a t i o (E) as the dependent v a r i a b l e and c o m b i n a t i o n s o f the above v a r i -a b l e s n , r , Y , e t c . , as the i n d e p e n d e n t v a r i a b l e s . I t was stested u s i n g m o n t h l y d a t a f o r each i n d i v i d u a l bank and a l s o u s i n g m o n t h l y d a t a f o r the b a n k i n g sys tem as a w h o l e ; Tes t s on I n d i v i d u a l Bank D at a : The model was f i r s t used t o d e t e r m i n e w h e t h e r a l o n g t e r m or s h o r t term i n t e r e s t r a t e e f f e c t e d banks: cash r e s e r v e b e h a v i o u r most ( T a b l e I I I , e q u a t i o n s 1 and 2 ) . W i t h the s h o r t t e rm r a t e ( r ) i n c l u d e d , the model has a 2 s l i g h t l y b e t t e r R t h a n w i t h the l o n g term r a t e (0) b u t more i m p o r t a n t the s h o r t t e rm r a t e i s s i g n i f i c a n t a t the f i v e p e r c e n t l e v e l w h i l e the l o n g term r a t e i s n o t . T h u s , as was m e n t i o n e d i n C h a p t e r Two, t h e s h o r t term r a t e i s a b e t t e r d e t e r m i n a n t o f bank cash r e s e r v e b e h a v i o u r t h a n the l o n g t e rm r a t e . Then the dummy v a r i a b l e s were added , one a t a t i m e , 2 and w i t h t h e i n c l u s i o n o f each e x t r a dummy v a r i a b l e the R i m p r o v e d , (Table I I I , e q u a t i o n s 3 , 4 , and 5). 2 In the l a s t and b e s t e q u a t i o n ( h i g h e s t R ) ( T a b l e I I I , e q u a t i o n 5) a l l the i n d e p e n d e n t v a r i a b l e s e x c e p t G ( t h i s m o n t h ' s d e p o s i t s o v e r l a s t ) are s i g n i f i c a n t at the f i v e p e r c e n t l e v e l , 5 6 SOURCE FOR TABLE I I I ( C o n t i n u e d ) - - S u r v e y o f C u r r e n t B u s i n e s s ; , U n i t e d S t a t e s Department o f Commerce, Bureau o f F o r e i g n and D o m e s t i c Commerce, W a s h i n g t o n . - - T w e l v e Y e a r s o f the Economic S t a t i s t i c s o f Canada , o p , c i t . , p p . 16-17 and - - M o n t h l y Review o f B u s i n e s s S t a t i s t i c s , D o m i n i o n Bureau o f S t a t i s t i c s , O t t a w a , K i n g 1 s P r i n t e r . h , I , G, S - - c a l c u l a t e d f rom d a t a i n Canada G a z e t t e , Volumes 19 20-19 3 9 , O t t a w a , K i n g ' s P r i n t e r , D^ , D^ - -Page 53of t h i s C h a p t e r . D^ - - A n n u a l R e p o r t s o f the d i f f e r e n t b a n k s . .'5 7 The s i g n s o f the c o e f f i c i e n t s are as e x p e c t e d i n a l l cases bu t t h r e e . The s i g n o f h (demand d e p o s i t s o v e r t o t a l d e p o s i t s ) i s n e g a t i v e , c o n t r a r y t o what was e x p e c t e d . No e x p l a n a t i o n c o u l d be found f o r t h i s . A l s o the s i g n o f S ( t o t a l d e p o s i t s ) i s p o s i t i v e , a g a i n c o n - • t r a r y t o what was e x p e c t e d . However , i n t h i s case we found i n C h a p t e r Four t h a t the l a r g e r banks h e l d g r e a t e r r e s e r v e s t h a n s m a l l e r banks and thus the p o s i t i v e c o e f f i -c i e n t i s i n agreement w i t h t h i s . F i n a l l y the s i g n o f r ( the New Y o r k c a l l l o a n r a t e ) i s p o s i t i v e , a g a i n c o n t r a r y t o e x p e c t a t i o n s . No e x p l a n a t i o n c o u l d be; found f o r t h i s e i t h e r . The v e r y s m a l l c o e f f i c i e n t s f o r i m p o r t s ( Y ) , c a r l o a d i n g s ( C ) , and t o t a l d e p o s i t s (S) i s a r e s u l t o f the magni tude o f the d a t a u s e d , w h i c h i s a l l measured i n thousands , compared t o t h e dependent v a r i a b l e E w h i c h i s measured as a d e c i m a l ( .09 b e i n g n i n e p e r c e n t ) . 2 Even though the b e s t R o b t a i n e d was o n l y .3778 t h i s does no t mean t h a t the model i s u s e l e s s . Because o f t h e l a r g e number o f o b s e r v a t i o n s (2882) and t h e g r e a t 2 d i v e r s i t y among banks t h e low R i s u n d e r s t a n d a b l e . I t w i l l be seen t h a t the p e r f o r m a n c e o f the model i s much i m p r o v e d when we aggrega te o v e r banks and t e s t the model w i t h d a t a f o r the whole C a n a d i a n b a n k i n g s y s t e m . 58 T e s t s on C a n a d i a n B a n k i n g Systemi Data A g a i n as i n the t e s t s on the i n d i v i d u a l bank d a t a , u s i n g r i n s t e a d o f 0 i n c r e a s e s the R 2 s l i g h t l y . A l s o r i s more s i g n i f i c a n t t h a n 0, a l t h o u g h at t h i s s t age b o t h are h i g h l y i n s i g n i f i c a n t . ( T a b l e I V , e q u a t i o n s 1 and 2 ) . 2 L i k e w i s e the R o f t h e s e e q u a t i o n s i m p r o v e s as we a d d . f u r t h e r dummy v a r i a b l e s ( T a b l e IV e q u a t i o n s 3 and 2 4) f i n a l l y we a c h i e v e a f a i r l y r e s p e c t a b l e R o f . 6 6 0 6 . In the f i n a l e q u a t i o n a l l bu t two o f the i n d e p e n d e n t v a r i -a b l e s are s i g n i f i c a n t at the. f i v e p e r c e n t l e v e l . C ( c a r - ' l o a d i n g s ) and G ( t h i s months^ d e p o s i t s o v e r l a s t ) a re i n s i g n i f i c a n t . A l l b u t two o f the c o e f f i c i e n t s have the s i g h s e x p e c t e d . I ( i n t e r b a n k d e p o s i t s o v e r t o t a l d e p o s i t s ) has a n e g a t i v e c o e f f i c i e n t whereas i t was e x p e c t e d t o be p o s i t i v e and r (New York c a l l l o a n r a t e ) has a p o s i t i v e s i g n whereas i t was e x p e c t e d t o b e ' n e g a t i v e . A g a i n no ex- • p l a n a t i o n . c o u l d be f o u n d f o r t h i s . U n l i k e w i t h i n d i v i d u a l bank d a t a , S ( t o t a l dep-o s i t s ) now has t h e s i g n e x p e c t e d ( n e g a t i v e ) . T h i s i s because of. a g e n e r a l downward t r e n d i n cash r e s e r v e h o l d i n g s o v e r t i m e . For the i n d i v i d u a l bank d a t a t h i s i s o f f s e t by the l a r g e r r e s e r v e h o l d i n g s o f l a r g e banks compared t o s m a l l 60 banks b u t l o o k i n g a t t h e w h o l e b a n k i n g s y s t e m we g e t o n l y t h e one e f f e c t , a d e c l i n e o v e r t i m e o f c a s h r e s e r v e s w h i l e t o t a l - d e p o s i t s i n c r e a s e . C o n c l u s i o n s U s i n g t h e a g g r e g a t e d d a t a f o r t h e C a n a d i a n b a n k i n g 2 s y s t e m we g e t a much h i g h e r R t h a n w i t h t h e i n d i v i d u a l bank d a t a . However , t h a t we can p r e d i c t b e t t e r g roup b e h a v i o u r t h a n i n d i v i d u a l b e h a v i o u r does n o t mean we s h o u l d f o r e s a k e t h e sdidy o f i n d i v i d u a l b e h a v i o u r t o c o n -c e n t r a t e on group b e h a v i o u r . As shown i n t h i s t h e s i s t h e mode l p r e s e n t e d c a n s h e d some l i g h t on i n d i v i d u a l bank b e h a v i o u r and w i t h f u r t h e r r e f i n e m e n t i t i s hoped i t caald shed much more . TABLE 1 1 1 REGRESSIONS ON INDIVIDUAL BANK DA T A (Number o f o b s e r v a t i o n s 2882) Dep. V a r . 1. E 2 . E 3 . E 4 . E 5 . E C o n s t a n t 0 .0616 (0 .9458-02 ) 0 .0738 (0 .8249-02) 0 .0785 (0 .819 7-0 2) 0 .0782 (0 .819-02 ) 0 .0175 (0 .855-02 ) n +0.757-02 (0 .1466-02) +0.822-02 (0 .1162-02 ) +0.717-02 (0 .116-02 ) +0.723-02 (0 .116-02 ) +0.0199 (0 .131-02 ) - 0 . 3 5 6 - 0 7 ( 0 , 4 2 6 - 0 7) - 0 . 1 - 0 6 ( 0 . 5 3 - 0 7 ) - 0 . 7 8 5 - 0 7 ( 0 . 5 24-0 7) - 0 . 6 6 6 - 0 7 ( 0 . 5 2 5 - 0 7) - 0 . 3 4 4 3 - 0 6 (0 .5271-0 7) INDEPENDENT VARTAB LES 0 +0.147-03 ( 0 . 8 - 0 4 ) +0.125-02 ( 0 . 6 3 - 0 3 ) +0.109-02 (0 .625-03 ) + 0 . 104-02 (0 .62 4-0 3) +0.3311-02 ( 0 . 6 1 4 - 0 3) - 0 . 1 1 2 - 0 3 (0 .19-04 ) - 0 . 1 1 6 - 0 3 (0 .186 8-0 4) - 0 . 1 1 8 - 0 3 (0 .185-04 ) - 0 . 1 2 4 - 0 3 (0 ,18 7-04) - 0 . 8 5 9 - 0 4 (0 .18-04 ) SOURCE: Cash R a t i o E Graphs i n A p p e n d i x . n - - R e p o r t o f the R o y a l Commiss ion on B a n k i n g and C u r r e n c y i n Canada , O t t a w a , K i n g ' s P r i n t e r , 1933 , p . 4 1 . and Bank o f Canada A n n u a l  R e p o r t s , 1935 , 1936, 1937, 1938, and 1939 , O t t a w a , Bank o f Canada . Y —Trade o f Canada , Department o f Trade and Commerce, Domin ion Bureau o f S t a t i s t i c s , O t t a w a , K i n g ' s P r i n t e r . 0 - - P r i c e s and P r i c e I n d e x e s , Dominion Bureau o f S t a t i s t i c s , O t t a w a , K i n g ' s P r i n t e r , 1913-1929; 1913-1939 and Twelve Year s o f the Economic S t a t i s t i c s o f Canada , supplement t o the M o n t h l y Review o f B u s i n e s s S t a t i s t i c s , N o v . 1 9 3 1 , Domin ion Bureau o f S t a t i s t i c s , O t t a w a , K i n g ' s P r i n t e r , p p . 1 4 - 1 5 . H I G S D l R2 - 0 . 0 4 (0 .011) +0.021 /" FT FT _ /~\ f*\ *\ +0.457-02 +0.121-06 .3156 (0 .77-02) ( 0 . 6 8 - 0 2 ) ( 0 . 3 4 - 0 8) ( .0392) - . 0 4 1 5 ( .0110) +.0219 ( 0 . 7 7 - 0 2 ) +0.5732-02 +0.12-06 ,315 7 ( 0 . 6 9 - 0 2 ) ( 0 . 3 4 - 0 8 ) ( .0392) - 0 . 0 3 7 (0 .01 ) + 0 .02 (0 .769-02 ) +0.48-02 ( 0 . 6 8 7 - 0 2 ) +0.10 7-06 ( 0 . 3 8 5 - 0 8 ) + ( 0 .025 0 .343-02 ) ,3285 ( .0389) - 0 . 0 3 6 (0 .011 ) +0.021 (0 .768-02 ) + 0 .509-02 ( 0 . 6 8 6 - 0 2 ) +0.11-06 ( 0 . 3 8 5 - 0 8) + ( 0 .026 0 .343-02 ) ^ ( 0 .751-02 0 .288-02 ) .3301 ( .0388) - 0 . 0 4 2 2 ( .011) +0.028 ( .0 74-02) +0.85-0 2 ( 0 . 6 6 - 0 2 ) +0.121-06 •i • 0 .563-02 +0.447 .3778 ( .0 374) ( 0 , 3 2 4 - 0 8 ) ( 0 . 2 6 6 - 0 2 ] ( 0 . 2 7 7 - 0 2 ) TABLE i v REGRESSIONS ON CANADIAN BANKING SYSTEM DATA (Number o f O b s e r v a t i o n s = 240) INDEPENDENT VARIABLES 1 Dep. V a r . C o n s t a n t n Y 0 r C h I G S D 2 D 3 R 2 1. E 0 .0595 (0 .0210) +0.368-02 ( 0 . 1 6 1 - 0 2) - 0 . 1 7 4 4 - 0 6 (0 .572-07 ) - 0 . 182-04 (0 .919-04 ) - 0 . 4 1 7 - 0 4 (0 .2198-04) + .48 ( .0512) - . 8 8 2 7 ( .1299) - . 0 1 2 4 (0 .9109-02 ) ( • 0 . 706-08 ' 0 . 4 5 9 1 - 0 8) .4848 ( .0119) 2 . E 0 .0598 _C0 .0190) +0.2935-02 (0 .148-02 ) - 0 . 2 0 1 2 - 0 6 (0 .6 54 3-0 7) +0.5346-03 (0 .6785-03 ) - 0 . 3 8 2 4 - 0 4 (0 .215 3-04) +0.4744 (0 .0516) - 0 . 9 0 6 6 (0 .1311) - 0 . 0 1 2 3 (0 .9087-02 ) » ( • 0 .6304-08 ; 0 . 4217-08) .4861 C O 119) 3 . E 0 .1015 (0 .0181) +0.458-02 (0 .1362-02 ) -0 .2078-06 (0 .5931-07 ) + 0 .1546-02 (0 .631-03 ) -0 . 1392-04 (0 .198-04 ) +0.3938 (0 .0481) - 0 . 4 2 6 6 (0 .1365) - 0 . 5 3 7 7 - 0 2 (0 .8293-02 ) ( • 0 .3062-07 ; 0 .5114-0 8) +0.0247 (0 .3445-02) .5797 (.010 8) 4 . E 0 .1046 (0 .016 3) +0.4588-02 (0 .123-02 ) - 0 . 1 9 3 7 - 0 6 ( 0 . 5 35-0 7) +0.181-02 ( 0 . 5 6 9 3 - 0 3 ) - 0 . 2 4 0 3 - 0 4 (0 .1789-04 ) -+0.3648 (0 .0435) - 0 . 3 8 4 6 (0 .1230) +0.4064-02 (0 .75 7 7-0 2) • • 0 . 3385-07 ; 0 . 46 27-0 8) + 0 .0169 | ( 0 . 3 1 1 7 - 0 2 ) +0.0269 (0 .2281-02) .6606 (0 .9695-02 SOURCE: Same as T a b l e I I I . CHAPTER SIX CONCLUSIONS A f t e r s e t t i n g out t o s t u d y t h e r e s e r v e b e h a v i o u r o f C a n a d i a n C o m m e r c i a l Banks i t was f i r s t n e c e s s a r y t o b u i l d a model o f bank r e s e r v e b e h a v i o u r . T h i s was done a f t e r p r e s e n t i n g two o t h e r models w h i c h d i f f e r e d from mine i n t h a t they were meant to be t e s t e d u s i n g a g g r e g a t e d a t a ( d a t a f o r a group o f banks o r a b a n k i n g s y s t e m ) , whereas mine was c o n s t r u c t e d t o be t e s t e d u s i n g i n d i v i d u a l bank d a t a . B e f o r e t e s t i n g the model i t was n e c e s s a r y t o s t u d y the c o n c e p t and measurement o f r e s e r v e s ' i n the C a n a d i a n c o n -t e x t because t h e r e was no r e q u i r e d r e s e r v e r a t i o and no o f f i c i a l d e f i n i t i o n o f r e s e r v e s d u r i n g the p e r i o d under s t u d y . However , t h e r e was a g e n e r a l l y p r e v a l e n t i d e a t h a t the C a n a d i a n c o m m e r c i a l banks d i d adhere t o a t e n p e r cen t r e s e r v e t h r o u g h a g e n t l e m e n ' s agreement w i t h i n the C a n a d i a n Banker s A s s o c i a t i o n . A r r i v i n g a t some p o s s i b l e r e s e r v e r a t i o s , the se were c a l c u l a t e d u s i n g m o n t h l y d a t a f o r the i n d i v i d u a l b a n k s . I t was d e c i d e d t h a t the Cash R a t i o (E) was the one p e o p l e meant when t h e y r e f e r r e d t o t h e banks h o l d i n g t e n p e r cent r e s e r v e s . A f t e r g r a p h i n g t h i s r a t i o f o r each bank i t was 62 seen t h a t a l l the banks, d i d n o t adhere t o the t e n p e r cent r e s e r v e n o r d i d . a n y one bank c o n s i s t e n t l y . Some e v i d e n c e was found r e f u t i n g George M o r r i s o n ' s c l a i m t h a t C a n a d i a n banks d i d n o t e x p e r i e n c e an i n c r e a s e i n r e s e r v e s d u r i n g the G r e a t D e p r e s s i o n . The mode 1 p r e s e n t e d e a r l i e r i n the t h e s i s was t h e n t e s t e d w i t h i n d i v i d u a l bank d a t a and d a t a f o r the whole Can-2 a d i a n b a n k i n g s y s t e m . A l t h o u g h the R f o r the model t e s t e d w i t h i n d i v i d u a l b a n k ' d a t a was n o t v e r y h i g h most o f the v a r i -a b l e s were s i g n i f i c a n t and had the e x p e c t e d s i g n . T e s t e d 2 w i t h d a t a f o r the whole b a n k i n g sys tem the R was much h i g h e r because o f some d e t a i l b e i n g h i d d e n by a g g r e g a t i o n . I t i s hoped t h a t w i t h f u r t h e r r e f i n e m e n t the model c o u l d be made t o b e t t e r p r e d i c t i n d i v i d u a l bank b e h a v i o u r . By u s i n g d i s a g g r e g a t e d d a t a ( w h i c h was p o s s i b l e because o f the s m a l l number o f C a n a d i a n banks ) much i n t e r -e s t i n g d e t a i l was r e v e a l e d w h i c h o t h e r w i s e i s l o s t i n aggre -g a t i o n . Some m i s c o n c e p t i o n s were a l s o c l e a r e d up w h i c h r e s u l t f rom c o n c l u s i o n s b e i n g made about i n d i v i d u a l bank b e h a v i o u r , by s t u d y i n g d a t a f o r a whole b a n k i n g s y s t e m . APPENDIX Graphs: o f Reserve R a t i o s o f C a n a d i a n Banks T T T T T T T "H" T T T T i~r T T T T T " T T T T T T T T T T T T T T T " T T T T " T X O T "TTTT "TTTT. TTTT TTTT TT1 IO X IO TO T H E CENTIMETER 23 X 30 CM. 47 1510 HADE IN U. 3. A. o o IO X 10 T O T H E C E N T I M E T E R 4 7 1 5 1 0 3 X 3 0 C M . ' . ' MADf! IN U . S . A . K E U F F E L C E S S E R C O . • I T t i l ; t i ; ' 1 r-it-r- ii i- 1- i i i i -r —r i ' 1 i ! i : t r rr i : r ! Hi- -r-ri-i- -r-U-i- ^-i— -f—f-r -r4—f- —+*-S B S 2 jh+r : 2 : <r o CO o 5-«. 3-BIBLIOGRAPHY Books A l l e n , R . G . D . , M a t h e m a t i c a l E c o n o m i c s . ; L o n d o n , M a c m i l l a n , 19 5 7 . ~~ A u b u r n , II.W. e d . C o m p a r a t i v e B a n k i n g i n A u s t r a l i a , A u s t r i a , e t c . D u n s t a b l e , Water low and S o n s , 1966 . B e c k h a r t , B e n j a m i n H a g g o t t . "The B a n k i n g System o f C a n a d a . " F o r e i g n B a n k i n g Systerns e d s . H . P . W i l l i s and B . H . B e c k h a r t , New Y o r k , Henry H o l t , 1929 . B j e r r i n g , J . H . , Dempster , J . R. H . , and H a l l , R. H . U . B . C . T r i p . The U n i v e r s i t y o f B r i t i s h C o l u m b i a Computing C e n t r e , F e b r u a r y , 1969 . C a n a d i a n Banker s A s s o c i a t i o n , Bank A c t R e v i s i o n P r o c e e d i n g s . C a n a d i a n Banker s A s s o c i a t i o n , 1933. G a l b r a i t h , J . A . "• The Economics o f B a n k i n g O p e r a t i o n s . M c G i l l U n i v e r s i t y P r e s s , 1 9 6 3 . G o l d f e I d , S. M . C o m m e r c i a l Bank B e h a v i o u r and Economic A c t i v i t y , Amsterdam, N o r t h - H o l l a n d , 1966 . J a m i e s o n , A , B . C h a r t e r e d B a n k i n g i n Canada,. T o r o n t o , R y e r s o n , 1953 . M c l v o r , R. C r a i g . C a n a d i a n Monetary . , B a n k i n g and T a s c a 1 Dev- ; e l o p m e n t . T o r o n t o , M a c m i l l a n , 195 8 . M o r r i s o n , G e o r g e . L i q u i d i t y P r e f e r e n c e s o f Commerc i a l B a n k s . U n i v e r s i t y o f C h i c a g o ' P r e s s , 1966 . N e u f e l d , E . P . e d . Money and B a n k i n g i n C a n a d a . T o r o n t o , M c C l e l l a n d and S t e w a r t L t d . , 1964. O ' B r i e n , J . W. C a n a d i a n Money and B a n k i n g . Toronto, McGrawy H i l l , 19 6 4 . S c h u l 1 , J o s e p h . 100 Y e a r s o f B a n k i n g i n Canada- -a H i s t o r y o f t h e T o r o n t o - D o m i n i o n Bank . T o r o n t o , C o p p - C l a r k , 195 8. 85 T e i g e n , R. L . "The Demand f o r and S u p p l y o f M o n e y " . Read ings i n N a t i o n a l Tncpme;' and S t a b i l i z a t i o n P o l l c y , e d s . W. L . S m i t h and R. L , T e i g e n , Homewood, I r w i n , 1965, p p i 4 4 - 7 6 . T h e i l , H . L i n e a r A g g r e g a t i o n o f Economic Re 1 a t i o n s . A m s t e r -dam, N o r t h - H o l l a n d , 1 9 5 4 . T o b i n , J . " C o m m e r c i a l Banks as C r e a t o r s o f M o n e y " , B a n k i n g and Moneta ry S t u d i e s , e d . Deane C a r s o n , Homewood, I r w i n , 1963 , ( F o r the C o m p t r o l l e r o f the C u r r e n c y , U . S . T r e a s u r y ) . G o v e r n m e n t . P u b T i c a t i o n s . Canada . Bank o f Canada A c t . O t t a w a , K i n g ' s P r i n t e r , 1934. Canada . Bank o f Canada A n n u a l R e p o r t . O t t a w a , 19 36 , 1937, 1938, 1939, 1940. Canada G a z e t t e . Volumes 1920-1939 , O t t a w a , K i n g ' s P r i n t e r . Canada . M o n t h l y . Review o f B u s i n e s s S t a t i s t i c s . O t t a w a , D o m i n i o n Bureau o f S t a t i s t i c s . P r i c e s and P r i c e I n d e x e s . O t t a w a , Domin ion Bureau o f - S t a t i s t i c s , 1913-1929 , 1913-1939 . P r o c e e d i n g s o f the S e l e c t S t a n d i n g Committee on , B a n k i n g ; and; Commerce;. O t t a w a , K i n g ' s P r i n t e r , 1923* R e p o r t o f •the R o y a l Commiss ion on B a n k i n g and C u r r e n c y i n Canada . O t t a w a , K i n g ' s P r i n t e r , 1933. S t a n d i n g Committee on B a n k i n g and.Commerce . M i n u t e s o f P r o c e e d i n g s and E v i d e n c e R e s p e c t i n g the Bank o f Canada . O t t a w a , K i n g ' s P r i n t e r , NO. 1, 1939. Trade o f Canada . O t t a w a , Department o f Trade and Commerce, Domin ion B u r e a u o f S t a t i s t i c s . " T w e l v e Y e a r s o f the Economic S t a t i s t i c s o f C a n a d a " , supp lement t o the M o n t h l y Review o f B u s i n e s s S t a t i s t i c s , . O t t a w a , D o m i n i o n Bureau o f S t a t i s t i c s (Nov.: 1931) , p p . 14-15 . C a n a d a . Canada . C anada , Canada . Canada . 86 U n i t e d S t a t e s Senate Document N o . 584 , 61 s t C o n g r e s s , 2nd S e s s i o n . I n t e r v i e w s on t h e B a n k i n g and C u r r e n c y System o f Canada . W a s h i n g t o n , Government P r i n t i n g O f f i c e , 1910. U n i t e d S t a t e s . Survey o f C u r r e n t B u s i n e s s , W a s h i n g t o n , Department o f Commerce, Bureau o f F o r e i g n and D o m e s t i c B u s i n e s s . A r t i c l e s and P e r i o d i c a l s Aher i sdor f J . and K a n e s a t h a s a n , S. " V a r i a t i o n s i n the Money M u l t i p l i e r and T h e i r I m p l i c a t i o n s f o r C e n t r a l B a n k i n g " . M . M . F . ; S t a f f P a p e r s , V o l . 8 (Nov . 1960) p p , 1 2 6 - 1 4 5 . B r e c h l i n g , F . and C l a y t o n , G. " C o m m e r c i a l Banks P o r t f o l i o B e h a v i o u r " . Economic J o u r n a l , V o l . . 7 5 , N o . 298 ( J u n e , 1 9 6 4 ) , p p . 2 9 0 - 3 1 6 . B r u n n e r , K a r l . " A Case S tudy o f U.S 1 . 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