Aggregate reserve requirement

LINK_POOL:

What Is Aggregate Reserve Requirement?

Aggregate reserve requirement refers to the total amount of funds that all depository institutions are mandated by the central bank to hold in reserve. This quantity is calculated based on a percentage of their customer deposits and certain other liabilities. The aggregate reserve requirement falls under the broader financial category of monetary policy. Historically, central banks utilized this tool as a means of influencing the nation's money supply and ensuring the liquidity of the banking system. Although the Federal Reserve in the United States eliminated reserve requirements in 2020, the concept remains relevant in understanding the history of monetary policy and its application in other economies.

History and Origin

The concept of reserve requirements dates back centuries, evolving from banks' inherent need to hold a portion of deposits as a buffer against withdrawals. In the United States, formalized reserve requirements were established with the creation of the Federal Reserve System in 1913. Initially, these requirements aimed to promote bank liquidity and stability. Over time, their role shifted to become a tool for monetary policy, influencing the availability of credit and the overall money supply. The Federal Reserve Act authorized the Board of Governors to impose these requirements on various types of deposits and liabilities of depository institutions. Prior to March 26, 2020, the Federal Reserve maintained reserve requirement ratios on net transaction accounts, with differing percentages based on the amount of such accounts held by institutions²⁵. However, on March 15, 2020, the Board reduced reserve requirement ratios to zero percent, effectively eliminating them for all depository institutions, a change that became effective on March 26, 2020²³, ²⁴. This move largely reflected a shift in the Federal Reserve's approach to implementing monetary policy, moving towards a system of "ample reserves" where the emphasis is on managing interest rates by adjusting the interest paid on reserves, rather than controlling the quantity of reserves through requirements²².

Key Takeaways

• The aggregate reserve requirement was the total amount of funds all banks were required to hold by the central bank.
• Historically, it served as a monetary policy tool to manage the money supply and bank liquidity.
• In the United States, the Federal Reserve eliminated reserve requirements for all depository institutions in March 2020.
• Despite their elimination in the U.S., reserve requirements continue to be a component of monetary policy in some other countries.
• The shift away from reserve requirements in the U.S. reflects a change in the central bank's approach to influencing the economy.

Formula and Calculation

Prior to March 26, 2020, when the Federal Reserve maintained reserve requirements, the aggregate reserve requirement for a single depository institution was calculated as follows:

Where:

• (R_R) = Required Reserves for a single institution
• (D_E) = Net transaction accounts up to the reserve requirement exemption amount (subject to 0% ratio)²¹
• (D_{LT}) = Net transaction accounts above the exemption amount and up to the low reserve tranche (subject to 3% ratio)²⁰
• (D_{OT}) = Net transaction accounts above the low reserve tranche (subject to 10% ratio)¹⁹

The aggregate reserve requirement for the entire banking system would then be the sum of (R_R) for all depository institutions. The exemption amount and the low reserve tranche were indexed annually according to formulas specified in the Federal Reserve Act¹⁸. It is important to note that currently, in the United States, the reserve requirement ratio for all categories of net transaction accounts is zero percent, meaning the required reserves (R_R) for any institution are also zero¹⁷.

Interpreting the Aggregate Reserve Requirement

In historical contexts, interpreting the aggregate reserve requirement involved understanding its implications for the overall financial system and the money supply. A higher aggregate reserve requirement meant that banks had to hold a larger portion of their deposits, limiting the amount available for lending. This restriction could lead to a contraction in the money supply and potentially higher interest rates, as banks would have less to lend and might charge more for available funds. Conversely, a lower aggregate reserve requirement freed up more funds for lending, potentially stimulating economic activity and increasing the money supply. Central banks would adjust these requirements as part of their monetary policy to achieve specific economic objectives, such as controlling inflation or fostering economic growth.

Hypothetical Example

Consider a hypothetical country where the central bank imposes a tiered reserve requirement similar to the historical U.S. model. Assume there are three banks: Bank A, Bank B, and Bank C.

• Reserve Requirement Exemption Amount: $50 million (0% reserve ratio)
• Low Reserve Tranche: From $50 million to $500 million (3% reserve ratio)
• Over Tranche: Above $500 million (10% reserve ratio)

Now, let's look at their net transaction accounts:

• Bank A: $40 million
• Bank B: $300 million
• Bank C: $800 million

Calculations:

• Bank A: Since $40 million is less than the exemption amount, its required reserves are ( $40 \text{ million} \times 0% = $0 ).
• Bank B:
  • Exemption portion: ( $50 \text{ million} \times 0% = $0 )
  • Low reserve tranche portion: ( ($300 \text{ million} - $50 \text{ million}) \times 3% = $250 \text{ million} \times 0.03 = $7.5 \text{ million} )
  • Total required reserves for Bank B: ( $0 + $7.5 \text{ million} = $7.5 \text{ million} )
• Bank C:
  • Exemption portion: ( $50 \text{ million} \times 0% = $0 )
  • Low reserve tranche portion: ( ($500 \text{ million} - $50 \text{ million}) \times 3% = $450 \text{ million} \times 0.03 = $13.5 \text{ million} )
  • Over tranche portion: ( ($800 \text{ million} - $500 \text{ million}) \times 10% = $300 \text{ million} \times 0.10 = $30 \text{ million} )
  • Total required reserves for Bank C: ( $0 + $13.5 \text{ million} + $30 \text{ million} = $43.5 \text{ million} )

Aggregate Reserve Requirement:

The aggregate reserve requirement for these three banks would be the sum of their individual required reserves:

( $0 + $7.5 \text{ million} + $43.5 \text{ million} = $51 \text{ million} )

This total represents the collective amount these banks are legally required to hold as reserves. Any funds held above this amount would be considered excess reserves.

Practical Applications

Historically, the aggregate reserve requirement was a significant tool within monetary policy. Central banks could adjust the reserve ratios to influence the amount of funds available for lending in the economy. For instance, increasing the aggregate reserve requirement would reduce the volume of deposits that banks could lend, thereby contracting the money supply and potentially curbing inflation. Conversely, decreasing the requirement would expand the money supply, encouraging lending and stimulating economic growth.

In the U.S., the Federal Reserve utilized this tool, alongside open market operations and the discount rate, to achieve its dual mandate of maximum employment and price stability. However, with the shift to a zero reserve requirement in March 2020, the direct application of aggregate reserve requirements as a primary monetary policy instrument has ceased in the United States¹⁶. Other central banks globally still use reserve requirements as part of their toolkit, tailoring their application to their specific economic contexts and policy objectives. An analysis by the International Monetary Fund (IMF) has explored how central banks utilize various tools to stabilize prices and output, including the use of reserve requirements in certain contexts¹⁴, ¹⁵.

Limitations and Criticisms

While reserve requirements were once a cornerstone of monetary policy, they faced several limitations and criticisms that ultimately led many central banks, including the Federal Reserve, to reduce or eliminate them. One significant critique was that reserve requirements acted as a "tax" on depository institutions because reserves often earned little to no interest¹², ¹³. This cost could put regulated institutions at a competitive disadvantage compared to less regulated entities in the financial system.

Another limitation was the difficulty in precisely controlling the money supply through reserve requirements. Banks could employ strategies like sweep accounts to reduce their required reserves, thereby making the impact of reserve requirement changes less predictable¹⁰, ¹¹. Furthermore, abrupt changes to reserve requirements could cause liquidity problems for banks with low excess reserves and disrupt financial markets⁹. Many economists and policymakers argued that other monetary policy tools, such as open market operations and adjustments to the federal funds rate or the interest paid on reserves, offered a more precise and flexible means of influencing economic conditions⁷, ⁸. The Bank Policy Institute, for example, argued that setting reserve requirements to zero would increase the supply of credit and reduce money market turmoil⁶.

Aggregate Reserve Requirement vs. Required Reserves

While often used interchangeably in casual conversation, "Aggregate Reserve Requirement" and "Required Reserves" have distinct meanings, though they are closely related.

In essence, individual "required reserves" contribute to the "aggregate reserve requirement." When a central bank, like the Federal Reserve, sets reserve ratios, each bank calculates its own required reserves. The sum of these individual requirements constitutes the aggregate figure for the entire banking system.

FAQs

What is the purpose of an aggregate reserve requirement?

Historically, the primary purpose of an aggregate reserve requirement was to influence the amount of money banks could lend, thereby controlling the overall money supply and fostering financial stability. It also ensured banks held a certain level of liquidity to meet depositor withdrawals.

Are aggregate reserve requirements still used in the United States?

No, the Federal Reserve reduced reserve requirement ratios for all depository institutions to zero percent, effective March 26, 2020. This means banks in the U.S. are no longer legally required to hold a specific percentage of their deposits as reserves⁴, ⁵.

How do central banks manage the money supply if there are no reserve requirements?

Even without reserve requirements, central banks can still effectively manage the money supply and influence interest rates. They primarily do this through open market operations, where they buy or sell government securities to inject or withdraw funds from the banking system. Additionally, they use tools such as the interest paid on excess reserves and the discount rate to influence banks' lending decisions and the federal funds rate³.

Did the elimination of reserve requirements make banks riskier?

The elimination of reserve requirements in the U.S. does not necessarily make banks riskier. Regulatory frameworks, such as capital requirements and liquidity regulations, remain in place to ensure bank safety and soundness. Banks still hold reserves, often as excess reserves, for operational purposes like settling transactions and managing their own liquidity needs, even without a specific mandate¹, ².