Introduction
Bank reserves are the essential cash minimums that financial institutions must maintain to adhere to central bank requirements. This tangible paper money is either stored in the bank’s vault or held in its account at the central bank. Cash reserve requirements ensure that every bank has enough liquidity to meet unexpected withdrawal demands, thus preventing potential financial crises.
Key Insights About Bank Reserves
- Bank reserves are the minimum cash amount banks must keep available to address unexpected demands.
- Excess reserves refer to any additional funds a bank keeps beyond the required minimum, often opting to retain these funds instead of lending them out.
- Reserving cash prevents the panic that can arise if customers realize the bank can’t fulfill immediate withdrawal requests.
- Bank reserves can be stored in the bank’s vault, with larger regional banks, or even at the Federal Reserve facilities.
- Historically, the reserve rate in America has fluctuated between zero to 10% of bank deposits.
How Bank Reserves Function
Bank reserves serve as a preventive mechanism against financial panic. Central banks mandate a minimum reserve to ensure banks never run out of cash, avoiding scenarios where customers’ withdrawal demands cannot be met. This precaution plays a pivotal role in preventing bank runs.
Additionally, central banks use reserve levels as an important tool for monetary policy. Adjusting these requirements can either free banks to issue more loans (stimulating economic activity) or pull back to slow down economic growth. While central banks in developed economies now frequently use quantitative easing, raising or lowering reserve requirements remains a prominent strategy in many emerging economies like China.
Effective March 26, 2020, the U.S. Federal Reserve reduced the cash reserve minimum to zero percent in response to the global pandemic.
Required and Excess Bank Reserves
- Required Reserves: The minimum amount of cash a bank must hold based on central bank regulations.
- Excess Reserves: Any funds above the required minimum, which banks usually avoid keeping as these reserves don’t earn returns and are vulnerable to inflation.
Even in prosperous times, consumers and businesses tend to borrow and spend more, increasing economic activity. Conversely, during recessions, borrowing decreases, and lending standards toughen, leading to higher reserve levels as banks opt to reduce default risks.
Historical Background
Before the Federal Reserve System was established in 1913, the U.S. lacked a cohesive national banking system, often resulting in financial instability. The creation of the Federal Reserve aimed to stabilize the nation’s financial condition, a role further expanded during the inflation crises of the 1970s. The central bank’s new objectives included price stability and economic growth, represented within the Federal Open Market Committee (FOMC).
Special Considerations
Central bank regulations follow a specific formula to determine each bank’s required reserve ratio, based on its net transaction accounts. This system ensures that the monetary policy is effectively managed, influencing the economy’s borrowing dynamics.
Liquidity Coverage Ratio (LCR): Post the collapse of Lehman Brothers in 2008, regulations like the Basel III Accords were introduced, requiring banks to maintain a liquidity rate to comfortably handle 30 days’ worth of outflows during a crisis.
The Impact of the ‘08 Financial Crisis
Prior to 2008, banks earned no interest on reserves they kept. This changed with the introduction of the Emergency Economic Stabilization Act of 2008, allowing banks to earn interest even on reserves. Despite the Pump-Priming by the Federal Reserve, banks prioritized holding onto these funds as excess reserves for their assured, risk-free interest returns over disbursing riskier loans.
Common Questions
How Much Money Do Banks Need to Keep in Reserve? Historically, reserve amounts fluctuate between zero and 10%. Since March 26, 2020, it stands at zero.
Are Bank Reserves Assets or Liabilities? Bank reserves are considered assets and are recorded as such on the bank’s balance sheet.
How Are Bank Reserves Calculated? To calculate, multiply the bank’s total deposits by the reserve ratio. For example, with $500 million in deposits and a 10% reserve ratio, the required reserve is $50 million.
Where Do Banks Keep Their Reserves? Some reserves are kept in the bank’s vault, while others are stored in a bigger bank or in accounts at regional Federal Reserve Banks, especially during peak demand periods like holidays.
Conclusion
The pre-Federal Reserve banking landscape was characterized by frequent instability. The establishment of centralized banking regulations, including minimum reserve requirements, has contributed to the stability of modern banking systems. The resilience of the system is currently underpinned by voluntary reserves combined with liquidity coverage requirements.
Related Terms: central bank, Federal Reserve, reserve ratio, monetary policy, bank run, quantitative easing, liquidity coverage ratio, Basel Accords
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”.
