What Are Bank Reserves?
Bank reserves are the cash minimums that financial institutions must have on hand to meet central bank requirements. This is real paper money that must be kept by the bank in a vault on-site or held in its account at the central bank. Cash reserve requirements are intended to ensure that every bank can meet any large and unexpected demand for withdrawals.
In the United States, the Federal Reserve dictates the amount of cash, called the reserve ratio, that each bank must maintain. Historically, the reserve ratio has ranged from zero to 10% of bank deposits.
- Bank reserves are the minimal amounts of cash required to handle unexpected demand.
- Excess reserves are additional cash that a bank chooses to hold instead of lending out.
- Bank reserves are used to prevent panic in cases of unexpectedly high withdrawal demands.
- Bank reserves are stored in vaults on-site or maintained in accounts at central banking facilities.
- Historically, American banks have had a reserve rate set between zero and 10%.
How Bank Reserves Work
Bank reserves act as an antidote to panic by ensuring banks can meet withdrawal demands. The Federal Reserve obliges banks to hold a certain amount of cash in reserve to avoid running short and potentially triggering a bank run.
A central bank can also utilize bank reserve levels as a tool in monetary policy. It can lower the reserve requirement so that banks can issue more loans, encouraging economic activity. Conversely, it can increase the reserve requirements to slow economic growth.
In recent years, central banks have adopted other strategies, such as quantitative easing (QE), to meet these objectives. While developed economies like the U.S. have shifted to such tactics, emerging economies like China continue using adjustments in bank reserve levels to manage their economic fluctuations.
The Federal Reserve cut the cash reserve minimum to zero percent effective March 26, 2020, in response to the global pandemic.
Required and Excess Bank Reserves
Bank reserves can be defined as either required reserves or excess reserves. The required reserve is the minimum cash a bank must keep on hand. Excess reserves are any funds over this minimum, which banks hold in their vaults rather than lending out.
Banks have little incentive to maintain excess reserves because holding cash yields no returns and may lose value over time due to inflation. Banks typically minimize their excess reserves to maximize the money they lend out.
During economic booms, businesses and consumers borrow and spend more. In recessions, borrowing decreases as banks become more conservative with lending to avoid defaults.
Bank reserves decrease during periods of economic expansion and increase during recessions.
History of Bank Reserves
Despite the efforts of historical figures like Alexander Hamilton, the U.S. lacked a consistent national banking system until the Federal Reserve System was founded in 1913 following the financial panic of 1907. Initially, banks were regulated by states, often leading to bank collapses and frequent runs on banks.
The Federal Reserve’s role significantly expanded in 1977 when Congress mandated price stability as a national policy goal, tasking the Federal Open Market Committee (FOMC) with its implementation.
Special Considerations
The required bank reserve follows a formula set by Federal Reserve Board regulations, based upon the total amount deposited in the bank’s net transaction accounts.
This figure includes demand deposits, automatic transfer accounts, and share draft accounts. Net transactions are calculated as the total in transaction accounts minus the funds due from other banks and money in the process of being collected.
Central banks use the reserve ratio as a tool for monetary policy, influencing the amount of money available for borrowing.
Liquidity Coverage Ratio (LCR)
Besides Federal Reserve requirements, banks must also adhere to liquidity requirements set by the Basel Accords. Following the 2008 financial crisis, Basel III strengthened the regulations with the Liquidity Coverage Ratio (LCR), requiring banks to hold enough cash and liquid assets to address expected fund outflows over a 30-day period.
Even when the Federal Reserve lowers bank reserve minimums, banks must still adhere to the LCR requirements to ensure sufficient cash for short-term obligations.
Impact of the ‘08 Crisis
Before the 2008 financial crisis, banks earned no interest on their reserves. This changed with the Emergency Economic Stabilization Act of 2008 when the Federal Reserve began paying interest on bank reserves while cutting interest rates to boost loan demand.
Banks, however, preferred to hold on to reserves for a risk-free return rather than lend, leading to a spike in excess reserves despite unchanged required ratios.
Frequently Asked Questions
How Much Money Do Banks Need to Keep in Reserve?
The reserve amount has historically ranged from zero to 10%. Since March 26, 2020, it has been zero.
Are Bank Reserves Assets or Liabilities?
Bank reserves are considered assets and are listed as such in a bank’s accounts and annual reports.
How Are Bank Reserves Calculated?
A bank’s reserves are calculated by multiplying its total deposits by the reserve ratio. For example, if a bank’s deposits total $500 million and the required reserve is 10%, the bank’s required minimum reserve is $50 million.
Where Do Banks Keep Their Reserves?
Some reserves are stored in vaults on-site, while others are held in accounts at one of the 12 regional Federal Reserve Banks. Smaller banks may keep parts of their reserves at larger banks.
The Bottom Line
The banking system in the U.S. has evolved from a decentralized system rife with failures and volatility to the well-regulated Federal Reserve System that mandates minimum cash reserves. Since March 2020, the reserve minimum has been set at zero, reflecting confidence in the liquidity management abilities of modern financial institutions bolstered by Basel Accords requirements.
Related Terms: Federal Reserve, reserve ratio, monetary policy, liquidity coverage ratio, economic expansion.
References
- Board of Governors of the Federal Reserve System. “Reserve Requirements”.
- Federal Reserve Bank of St. Louis. “Making Sense of the Federal Reserve History and Purpose of the Federal Reserve”.
- Office of the Comptroller of the Currency. “1863 - 1865 Founding of the National Banking System”.
- U.S. Congress. “Public Law 95-188—Nov. 16, 1977”.
- Bank for International Settlements. “Basel III: International Regulatory Framework for Banks”.
- Bank for International Settlements. “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring”, Page 7.
- Govinfo.gov. “Public Law 110 - 343 - Emergency Economic Stabilization Act of 2008”.
- Federal Reserve. “Interest on Reserve Balances”.
- Federal Reserve. “FedCash Services”.
