Reserve Requirements of Banks

Reserve requirements of banks

You will learn about the following concepts

  • Changing the reserve requirements – how does it work?
  • Possible effects
  • Federal Reserve Bank’s practice
  • and more

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As we’ve already mentioned before, there are three ways for central banks to control money supply in an economy in an attempt to provide price stability, stable employment and overall robust economic growth. Central banks can impact the amount of money flowing by raising or lowering the interest rates, changing the reserve requirements of banks or by conducting open-market operations. Some of these methods are preferred more than others since they are more effective, but nevertheless they are all being used around the world.

Typically, central banks refrain from interfering in the economy, unless a major imbalance occurs and the value of the local currency needs to be protected and vice versa. This is because each intervention defies the free-market principles, according to which a currency’s value should be determined purely by supply and demand.

Moreover, given the role and status of the central banks, each decision they make has a broad-ranged impact on all subjects in the economy, especially if it is surprising and catches the markets off-guard. As we said before, some of the methods used for money supply control are less preferred than the rest as they are less efficient and can cause strong short-term disruptions, such as the reserve requirements of banks.

Reserve requirements of banks

money.poundsThe reserve requirements are a tool used by most central banks, but not all, which obligates commercial banks under their authority to hold a specific amount of their customers’ deposits and notes as a reserve. Those reserves must be physically stored in the form of cash in the bank’s vault or must be held as a deposit with the central bank.

The portion of the depositors’ balances which banks must maintain as reserves is referred to as the so-called “reserve ratio”, which basically translates in what percentage of its clients’ deposits a bank must hold as required reserves. Banks could also hold excessive reserves, which is the amount of extra cash stored above the minimum requirement.

Example

Bank ABC has $100 million in deposits with the central bank having previously set a minimum reserve requirement at 10%. This means that at any given time ABC must have at least $10 million of cash stored in its vault or in a deposit with the central bank and cannot use this money for lending or any other purpose. If ABC decides, it can hold a larger amount of money which exceeds the minimum required, the so-called excessive reserves. In our case, our Bank ABC could keep $15 million as reserves, of which $10 is the minimum required, which can’t be utilized in any way, and the other $5 million can be used as it wills.

How does it work

But how does changing the amount of money banks must store impact the currency’s value and by that, the economy overall? The reserve requirement affects the country’s interest rates by reducing or increasing the amount of money available for banks to loan to their clients.

Exclamation-iconWhen central banks decrease the (reserve requirement) ratios, they free up capital, which was previously held as reserves, and induces an expansion of bank credit.

When central banks increase the ratios, they force commercial banks to lock in capital, which otherwise could have been lent out, effectively reducing the amount of money flowing in the economy.

Similar effect

The implementation of the minimum reserve requirement derives its significance from the fact that by altering the money supply, this tool impacts the value of the local currency and ultimately has the same same effect as the central bank changing the interest rate.

money reservesIf a commercial bank is required to keep a larger amount of money as reserves, effectively reducing the amount of capital it can lend, this would make banks charge their borrowers more, or increase the interest rates. Although this would make the access to credit more expensive, thus reducing credit growth and in general ease economic activity, operating at higher rates will benefit savers, because they will earn a higher interest rate for the money they deposited in the banks. In most cases this would raise the value of the local currency because more foreign investors will want to benefit from the higher return rate, but in order to invest, they will need to buy local currency, thus increasing demand for it.

This logically works the other way around as well. If the central bank reduces the required amount of money banks must stash or deposit with it, this would free up liquidity, thus boosting credit activity and driving interest rates down. This would eventually curb the flow of foreign investments and reduce the demand for local currency.

Negative effects

Typically however, central banks avoid tampering with the amount of reserves banks must keep as such a shift usually changes dramatically their ability to lend money in both directions. An increase in the minimum reserve requirement could have an exceedingly harmful effect on smaller institutions and such with low excessive reserves.

business woman sleeping on money bedBanks follow the maxim that sleeping money doesn’t do you any good and given the fact they profit by lending out as much money as they can in return for earning the interest rate, it is quite normal for them to have a very small portion of their total assets in cash. Everything else is lent out in the form of loans and mortgages. This means that, if a central bank decides to raise its minimum reserve requirements, many commercial banks which haven’t expected such an intervention and hadn’t prepared for it will experience major difficulties in complying with the obligation in the short-term. This would introduce stress to the country’s banking system since as we know, all banks are linked together through the interbank market where they exchange liquidity on a daily basis.

Meanwhile, altering the reserves requirements also has the potential to lead to changes in pricing schedules for a number of bank services as some bank fees and credits are based on reserve requirements.

Having noted these negative aspects of using the minimum reserve requirement as a tool for monetary policy, most Western central banks rarely alter the reserve ratios and generally prefer to use open market operations, which will be thoroughly explained in the next chapter.

Federal Reserve

federal-reserveIn the United States, the Federal Reserve, whose decisions have a dominant significance on the financial markets, has set three levels of reserve requirements, based on the dollar amount of net transaction accounts held with the depository institutions. They are set as it follows:

– institutions with net transaction accounts totaling less than $12.4 million are required to keep 0% as reserves, this exemption amount will be raised to $13.3 million as of January 23rd 2014

– institutions with total net transaction accounts amounting to between $12.4 million and $79.5 million must keep reserves of 3%, the low-reserve tranche amount is due to be raised to between $13.3 and $89.0 million as of January 23rd 2014;

– institutions holding more than $79.5 million in net transaction accounts are obligated to have a liquidity ratio of 10%, the lower limit will be lifted to $89.0 million as of January 23rd 2014.

When you take a look at the level of change the Federal Reserve has introduced into the exemption amount and low-reserve tranche in the past 25 years, you will notice that central bankers have been steadily increasing them, but at a minor and gradual pace in the years before the Lehman Brothers collapse in order to avoid short-term disruptions. During these 20 years, the altered ratios had an overall mixed effect on the total amount of reserves held in the system.

Since the bankruptcy of Lehman Brothers, which marked the beginning of the late 2000-s global financial crisis, the Federal Reserve has been lifting both the exemption and low-reserve tranche amounts by a larger degree. These increases have ultimately been reducing the overall amount of reserves required in the system by shifting the weight from smaller onto bigger institutions.

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