What Are Bank Reserves?
Bank reserves are the cash holdings of commercial banks, including both physical cash held in a bank's vault (vault cash) and the funds held in that bank's account at the country's central bank. These reserves serve as a primary component of a bank's liquidity, enabling it to meet customer withdrawal demands and manage interbank transactions. As a fundamental aspect of monetary policy and banking regulation, the level of bank reserves directly impacts a financial institution's capacity for lending and its overall financial stability. Commercial banks maintain these reserves to ensure they can fulfill their obligations to depositors and other creditors. They are a liability for the central bank and an asset for the commercial bank.
History and Origin
The concept of bank reserves has evolved alongside the history of fractional reserve banking. Historically, banks held reserves as a safeguard against bank runs, where many depositors simultaneously sought to withdraw their funds. The formalization of reserve requirements emerged in the late 19th and early 20th centuries, particularly with the establishment of central banks. In the United States, the Federal Reserve Act of 1913 created the Federal Reserve System, mandating that member banks hold reserves in the form of Federal Reserve notes or deposits at their local Federal Reserve Bank. This was primarily intended to stabilize the American banking system and prevent financial panics that had plagued the nation.8,
Key Takeaways
- Bank reserves consist of cash held by banks in their vaults and deposits at the central bank.
- They are crucial for meeting customer withdrawal demands and facilitating interbank settlements.
- Central banks use reserve requirements as a tool for monetary policy, influencing the money supply and credit availability.
- The level of bank reserves can indicate the overall liquidity and stability of the financial system.
- Excess reserves, holdings above regulatory minimums, can play a significant role in a central bank's policy implementation.
Formula and Calculation
While "bank reserves" themselves are a balance sheet item, the amount of required reserves that banks must hold is often determined by a formula based on their deposit liabilities.
- Required Reserves: The minimum amount of funds a bank must hold in reserve as mandated by the central bank.
- Deposit Liabilities: The total amount of funds that customers have deposited into the bank.
- Reserve Ratio: The percentage of a bank's deposits that it must hold as reserves, set by the central bank.
For example, if a central bank sets a reserve ratio of 10% and a bank has $100 million in deposit liabilities, its required reserves would be $10 million.
Interpreting Bank Reserves
The level of bank reserves is a critical indicator for both individual financial institutions and the broader economy. For a bank, sufficient reserves ensure it can honor its commitments without facing a liquidity crisis. Holdings above the required amount are known as "excess reserves." Before the 2008 financial crisis, banks typically minimized excess reserves because they did not earn interest, making it more profitable to lend those funds.7
However, in many jurisdictions, including the U.S., central banks now pay interest rates on reserves, altering banks' incentives and allowing the central bank to influence market interest rates independently of the quantity of reserves. Large holdings of excess reserves, especially after periods of quantitative easing, have become a norm in many modern central banking frameworks.6
Hypothetical Example
Consider "Vanguard National Bank," which has $500 million in total deposit liabilities from its customers. The country's central bank has a reserve requirement of 5%.
- Calculate Required Reserves: Vanguard National Bank must hold ( $500 \text{ million} \times 0.05 = $25 \text{ million} ) as required reserves.
- Monitor Actual Reserves: Suppose Vanguard National Bank currently holds $30 million in its account at the central bank and $5 million in vault cash. Its total bank reserves are $35 million.
- Determine Excess Reserves: Since its required reserves are $25 million and it holds $35 million, Vanguard National Bank has ( $35 \text{ million} - $25 \text{ million} = $10 \text{ million} ) in excess reserves.
- Balance Sheet Impact: On Vanguard National Bank's balance sheet, the $35 million in reserves would be listed as an asset, while the $500 million in customer deposits would be a liability. The excess reserves provide a buffer, allowing the bank flexibility in lending or managing unexpected withdrawals.
Practical Applications
Bank reserves play a central role in the day-to-day functioning of the banking sector and the implementation of monetary policy. Central banks directly influence the overall level of bank reserves through tools like open market operations, such as buying or selling government securities. When the central bank buys securities, it credits the reserve accounts of commercial banks, increasing their reserves, and vice versa.
In response to financial crises, central banks have also engaged in large-scale asset purchases, often referred to as quantitative easing. These programs dramatically increase the amount of bank reserves in the system, aiming to inject liquidity and stimulate economic activity. This shift led to a substantial increase in bank reserves post-2008.5 The management of a central bank's balance sheet, which includes bank reserves as a key liability, is a significant aspect of modern monetary policy.4
Limitations and Criticisms
While essential for financial stability, the role and effectiveness of bank reserves, particularly reserve requirements, have faced scrutiny. A key criticism, especially in the wake of the 2008 financial crisis and subsequent quantitative easing, is that the sheer volume of excess reserves in the system may diminish the traditional impact of reserve requirements. When banks hold far more reserves than legally mandated, changes to the reserve requirement might have little practical effect on lending or the broader economy.3
Some argue that large excess reserves, particularly if they earn interest, can disincentivize interbank lending, impacting the Federal Funds Rate or equivalent overnight rates, and potentially fragmenting money markets.2 Moreover, the accumulation of reserves on central bank balance sheets, while a byproduct of crisis response, has spurred debates about potential inflationary pressures or challenges in normalizing monetary policy.1
Bank Reserves vs. Reserve Requirement
The terms "bank reserves" and "reserve requirement" are related but distinct. Bank reserves refer to the actual funds that a commercial bank holds, either as cash in its vault or as deposits at the central bank. This is an amount of money.
Conversely, the reserve requirement is a regulation set by the central bank that mandates the minimum percentage of a bank's deposit liabilities that it must hold in reserves. It is a ratio or a rule, not an amount of money itself. A bank's actual bank reserves can be equal to, greater than, or, in rare cases of deficiency, less than its reserve requirement. The central bank uses the reserve requirement as a tool to influence the money supply and the amount of funds available for lending in the economy.
FAQs
What happens if a bank doesn't have enough reserves?
If a bank falls short of its reserve requirement, it must quickly acquire the necessary funds. This can involve borrowing from other banks in the interbank market (often at the Federal Funds Rate in the U.S.) or borrowing from the central bank through its discount window. Persistent or severe reserve shortfalls can signal financial distress.
Do all countries have reserve requirements?
No, not all countries currently impose mandatory reserve requirements. Some central banks, like the Bank of England and the Bank of Canada, have eliminated them, opting to manage liquidity and monetary policy through other tools, such as interest rates on reserves and open market operations. The U.S. Federal Reserve also reduced its reserve requirement ratios to zero in March 2020.
What are excess reserves?
Excess reserves are the amount of bank reserves held by a bank that exceed the legally mandated reserve requirement. Historically, banks would minimize excess reserves to maximize their lending and profit. However, since the 2008 financial crisis, many central banks have paid interest on these reserves, leading banks to hold significant amounts of excess reserves.
How do bank reserves affect the economy?
Bank reserves indirectly influence the economy by impacting banks' ability and willingness to lend. When banks have ample reserves, they have more capacity to extend credit, which can stimulate economic activity. Conversely, tighter reserve conditions can restrict lending, potentially slowing economic growth. Central banks use these dynamics to conduct monetary policy.