Reserve requirements are the amount of cash that financial institutions must have in their vaults or at their nearest Federal Reserve bank, in relation to the deposits made by their customers. Set by the Federal Reserve’s Board of Governors, reserve requirements serve as one of the three main tools of monetary policy—the other two being open market operations and the discount rate.
Banks, credit unions, savings and loan associations, as well as U.S. branches and agencies of foreign banks must all adhere to reserve requirements. This regulatory measure ensures that the economy remains stable and capable of resisting sudden financial shocks.
On March 15, 2020, the Federal Reserve Board set reserve requirements ratios to 0%, effective March 26, 2020, a decision aimed at providing banks with greater flexibility during the economic upheaval caused by the COVID-19 pandemic.
Key Takeaways
- Guard Against Withdrawals: Reserve requirements ensure banks have enough funds on hand to meet liabilities during unexpected withdrawal surges.
- Economic Influence: As a crucial monetary tool, reserve requirements help control money supply and interest rates in the economy.
- Current Status: Reserve requirements are currently set at zero in response to the global pandemic, highlighting the duo role they play in economic stability and flexibility.
Understanding Reserve Requirements
Banks loan funds to customers based on a fraction of the cash they have on hand. In exchange for this lending capability, they are required to keep a certain amount of those deposits on hand, known as the reserve requirement. Essentially, this is the percentage of deposits that banks must maintain and are not allowed to lend out.
When banks find themselves short on cash to meet the reserve requirement, they have options: borrowing from other banks or utilizing the Federal Reserve’s discount window. The federal funds rate is the interest rate at which banks lend to each other and forms the basis for various other interest rates in the economy.
The Federal Reserve not only sets the reserve requirement but also the interest rate banks earn on excess reserves. Introduced via the Financial Services Regulatory Relief Act of 2006, this interest payment on excess reserves began on Oct. 1, 2008, acting as an incentive for banks to hold more than the minimum required reserves.
A change in reserve requirements directly impacts the economy’s liquidity. When the Fed reduces reserve requirements, it engages in an expansionary monetary policy, increasing money supply and economic activity. On the flip side, raising reserve requirements implements a contractionary monetary policy, reducing economic activity to rein in inflation.
Reserve Requirements History
The practice of maintaining reserves traces back to the first commercial banks of the early 19th century. The lack of consistency and reliability in banknotes among regional banks prompted banks in New York and New Jersey to establish mutual redemption arrangements, requiring deposit of gold or equivalents to ensure confidence.
The National Bank Act of 1863 further enforced this notion by setting a 25% reserve requirement for national banks, thereby standardizing bank notes as a medium of exchange and minimizing risks.
The 1913 establishment of the Federal Reserve created a well-rounded system, reducing former high reserve requirements and creating a federal structure aiming to stabilize banks as lenders of last resort. By 1917, reserve requirements ranged from 7% to 13%, depending on the bank type.
In response to the COVID-19 pandemic, the Federal Reserve set reserve requirement ratios to zero across all deposit tiers, aimed at enhancing liquidity and encouraging lending.
Dec. 23, 1913
This landmark date marks the day when President Woodrow Wilson signed the Federal Reserve Act into law, founding the Federal Reserve.
Reserve Requirements vs. Capital Requirements
While some countries like Canada, the United Kingdom, New Zealand, Australia, and Sweden do not have reserve requirements, they adhere to capital requirements. Capital requirements mandate financial institutions to hold a certain amount of their equity as prescribed by financial regulators, ensuring they can absorb losses.
In contrast, reserve requirements refer to the amount of liquid assets banks must hold, designed to protect them from sudden mass withdrawals. Surpassing the minimum required funds equates to holding what are known as free reserves.
Capital requirements primarily safeguard against risks such as loan defaults and market downturns, complementing the reserve requirements’ focus on liquidity.
Example of Reserve Requirements
Let’s consider an example. Assume a bank boasts $200 million in deposits with a 10% reserve requirement. This means the bank can lend out a staggering $180 million, facilitating bank credit, determining how much money banks can loan to customers.
Apart from bringing a buffer to countering bank runs and offering liquidity layer, reserve requirements also serve as a Federal Reserve’s monetary regulating tool. When increased, they absorb money from supply, thus higher credit costs, and when decreased, they inject money batting for economy’s growth by endorsing bank credit expansion and slashing rates.
Setting the Reserve Requirement
In the United States, the Federal Reserve Board of Governors sets reserve requirements, vested with this authority by the Federal Reserve Act. These requirements align with the broader objective of driving monetary policy efficiently across deposit institutions.
The Meaning of Lower Reserve Requirements
A lower reserve requirement signifies an expansionary monetary policy. Such a scenario allows banks to retain less cash on hand, freeing up more significant amounts for lending purposes to consumers and businesses.
The Repercussions of a Higher Reserve Requirement
Conversely, a higher reserve requirement indicates a tilt towards a contractionary monetary policy. Elevated reserve requirements mean fewer funds available for lending, providing banks with a better shield against potential economic downturns or bank runs.
Conclusion
Reserve requirements mandate the amount of cash financial institutions must have readily available to cover sudden withdrawals, shielding them from the brink of liquidity crunch. These funds can be held either in a vault or at a nearby Federal Reserve bank.
Adjustments in reserve requirements directly affect the amount banks can lend, thereby steering the broader economic forces of inflation, interest rates, and monetary supply. Elevating reserve requirements contracts the money supply, driving higher lending costs and rising interest rates, ultimately impacting the entire economy.
Related Terms: financial institutions, Federal Reserve bank, deposits, open market operations, discount rate, liquidity, excess reserves, federal funds rate, commercial banks
References
- Federal Reserve Board. “Reserve Requirements”.
- Federal Reserve. “Interest on Reserve Balances”.
- Federal Reserve Bank. “Navigating Constraints: The Evolution of Federal Reserve Monetary Policy, 1935-59”, Page 3, Footnote 7.
- Federal Reserve Bank. “Federal Reserve Act”.
- Federal Reserve Board. “The History of Cyclical Macroprudential Policy in the United States”.
- Federal Reserve. “Frequently Asked Questions”.
- U. S. Government Accountability Office. “Observations on Regulation D and the Use of Reserve Requirements”, Page 47.
- Federal Reserve Bank of Cleveland. “A Brief History of Bank Capital Requirements in the United States”.
