Between 2001 and 2007, the US economy experienced a boom and bust cycle in the mortgage market with serious ramifications for economic growth and job creation. Such financial cycles recur with some regularity. Existing regulatory tools have proven inadequate to address them. One possible alternative to achieve greater financial market stability may be asset-based reserve requirements (ABRRs). ABRRs would require all lenders to place with the Federal Reserve a specified percentage of loans as low or no interest bearing reserves. Reserves would be larger for riskier loans and could be adjusted according to economic needs.

ABRRs have several features that may have helped to smooth the large financial market swings after 2001. For one, ABRRs increase the tools at the Federal Reserve’s disposal to conduct monetary policy. Second, ABRRs directly influence lenders’ asset allocation decisions and thus could provide strong incentives to engage in less-risky lending strategies. Third, if ABRRs potentially replaced reserve requirements on deposits, they would impact a much larger share of the credit market, not just loans by deposit-taking institutions that fall under the Federal Reserve’s regulatory regime. Fourth, ABRRs could offset the procyclical bias of new capital adequacy standards and thus help to stave off too much credit tightening in an economic downturn.