Economic reserve requirement

Economic Reserve Requirement: Definition, Formula, Example, and FAQs

The economic reserve requirement is a central bank regulation that mandates the minimum amount of liquid assets, typically in the form of vault cash or deposits at the central bank, that commercial banks must hold against their liabilities, primarily customer deposits. This falls under the broader category of Banking Regulation, serving as a crucial tool for monetary policy and financial stability. The purpose of the economic reserve requirement is to ensure banks maintain sufficient liquidity to meet sudden withdrawals and to influence the overall money supply in an economy.

History and Origin

The concept of reserve requirements dates back centuries, evolving from the practice of early banks holding a portion of their deposits in reserve to meet client withdrawals. In modern economies, central banks formalized these requirements. For instance, in the United States, the Federal Reserve Board historically set reserve requirements for depository institutions, including commercial banks, savings banks, savings and loan associations, and credit unions. These requirements applied to transaction accounts, such as checking accounts. Prior to March 26, 2020, the Federal Reserve mandated specific reserve ratios based on the amount of net transaction accounts held by a depository institution¹³. However, as announced on March 15, 2020, the Federal Reserve Board reduced all reserve requirement ratios to zero percent, effectively eliminating them for all depository institutions¹¹, ¹². This move shifted the Federal Reserve's monetary policy implementation to an "ample-reserves" system, where banks are paid interest on excess reserves held at the central bank.

In contrast, other major central banks, like the European Central Bank (ECB), continue to implement minimum reserve requirements. The ECB requires credit institutions in the euro area to hold deposits with their national central banks, which are referred to as minimum or required reserves¹⁰. Since January 2012, the ECB has applied a uniform positive minimum reserve ratio, currently set at 1% of certain liabilities, primarily customer deposits and outstanding debt securities with a maturity of up to two years⁷, ⁸, ⁹.

Key Takeaways

• The economic reserve requirement mandates the minimum liquid assets banks must hold.
• It influences bank liquidity and the overall money supply.
• Central banks like the Federal Reserve historically used it as a monetary policy tool.
• The Federal Reserve reduced its reserve requirement ratios to zero in March 2020.
• Other central banks, such as the European Central Bank, still impose minimum reserve requirements.

Formula and Calculation

Historically, when the economic reserve requirement was actively used by the Federal Reserve, the calculation involved applying a specific ratio to a bank's reservable liabilities. For central banks that still impose them, like the European Central Bank, the calculation is similar.

The basic formula for calculating the required reserve is:

Where:

• Required Reserves: The amount of funds a commercial bank must hold in reserve.
• Reserve Ratio: The percentage set by the central bank.
• Depositable Liabilities: The total amount of customer deposits and other liabilities against which reserves must be held.

For instance, the ECB determines the amount of minimum reserves each bank must hold by applying the reserve ratio to its reserve base, which primarily consists of customer deposits and debt securities. A lump-sum allowance, currently €100,000, is deducted from this amount to reduce administrative costs for banks with very low minimum reserves.
⁵, ⁶

Interpreting the Economic Reserve Requirement

The economic reserve requirement serves as a lever for central banks to influence the financial system. A higher reserve ratio limits the amount of funds banks can lend out, thereby contracting the money supply and potentially increasing interest rates. Conversely, a lower reserve ratio frees up funds for bank lending, expanding the money supply and potentially lowering interest rates.

While the Federal Reserve has set its reserve requirement to zero, the concept remains relevant globally. In jurisdictions where reserve requirements are active, changes in the ratio signal the central bank's stance on monetary policy. For example, a central bank might lower the reserve requirement to stimulate economic growth during a downturn or raise it to combat inflation.

Hypothetical Example

Consider a hypothetical country where the central bank imposes an economic reserve requirement of 5%. If a commercial bank in this country receives new customer deposits totaling $100 million, it would need to calculate its required reserves.

1. Identify the Reserve Ratio: 5%
2. Identify Depositable Liabilities: $100 million
3. Calculate Required Reserves: $$\text{Required Reserves} = 0.05 \times \$100,000,000 = \$5,000,000$$

In this scenario, the bank must hold $5 million in reserves (either as vault cash or at the central bank) and can lend out the remaining $95 million. This illustrates how the economic reserve requirement directly impacts the amount of money available for lending, thereby influencing the economy through the principles of fractional reserve banking.

Practical Applications

Although the Federal Reserve has set its reserve requirement to zero, the concept still holds practical applications in many other countries and for understanding the historical context of monetary policy in the United States.

• Monetary Policy Tool: In countries where it is active, the economic reserve requirement is a direct tool for central banks to manage bank liquidity and the money supply. By adjusting the reserve ratio, authorities can influence the amount of funds available for lending, impacting borrowing costs and investment.
  ⁴* Bank Balance Sheet Management: For banks subject to these requirements, understanding the economic reserve requirement is critical for managing their balance sheet and ensuring compliance. They must accurately assess their reservable liabilities and hold adequate funds to meet the mandate.
  ³* Financial Stability: While not the sole determinant, reserve requirements can contribute to financial stability by ensuring banks maintain a basic level of liquid assets, which can act as a buffer against unexpected deposit outflows or market shocks. The International Monetary Fund (IMF) notes that reserve requirements can serve as a tool to manage banks' liquidity risk.
  ²

Limitations and Criticisms

While historically significant, the economic reserve requirement has faced several limitations and criticisms, leading some central banks, like the Federal Reserve, to abandon it as a primary monetary policy tool.

• Inefficiency as a Monetary Policy Tool: In modern financial systems, many central banks have found that adjusting interest rates and conducting open market operations are more effective and precise tools for managing liquidity and influencing the economy. The Federal Reserve, for example, determined that nonzero reserve requirements served no monetary policy purpose in its "ample reserve" framework.
  ¹* Distortion of Bank Behavior: High reserve requirements can reduce a bank's profitability by forcing it to hold a significant portion of its assets in low-yielding or non-interest-bearing reserves. This can disincentivize lending and potentially push banks towards riskier, less regulated activities to achieve higher returns.
• Liquidity Hoarding: During times of economic uncertainty or financial crisis, banks might hold reserves far in excess of the mandated requirement (known as excess reserves), regardless of the official ratio. This "liquidity hoarding" can undermine the effectiveness of reserve requirement adjustments as a stimulus measure, as banks may not lend out the newly freed funds.
• Capital Requirements vs. Reserve Requirements: Critics argue that capital requirements, which focus on a bank's overall solvency and ability to absorb losses, are a more robust prudential tool than reserve requirements, which primarily address liquidity.

Economic Reserve Requirement vs. Capital Requirement

The terms "economic reserve requirement" and "capital requirement" are often confused but serve distinct purposes in banking regulation.

While both aim to promote financial stability, the economic reserve requirement focuses on a bank's immediate ability to meet obligations, whereas the capital requirement addresses its long-term capacity to withstand financial shocks and absorb losses.

FAQs

Q1: What is the main purpose of an economic reserve requirement?
A1: The primary purpose of an economic reserve requirement is to ensure that banks maintain sufficient liquid assets to meet depositor withdrawals and to enable the central bank to influence the overall money supply and credit conditions in the economy.

Q2: Do all countries have economic reserve requirements?
A2: No, not all countries currently impose an economic reserve requirement. For instance, the United States Federal Reserve set its reserve requirement ratios to zero percent in 2020. However, many other central banks, such as the European Central Bank, still maintain minimum reserve requirements.

Q3: How does the economic reserve requirement affect the money supply?
A3: By setting a minimum amount of funds that banks must hold in reserve, the economic reserve requirement limits the amount of money banks can lend out. A higher requirement restricts lending, contracting the credit and money supply, while a lower requirement expands them.

Q4: What is the difference between required reserves and excess reserves?
A4: Required reserves are the minimum amount of funds a bank must hold as mandated by the central bank. Excess reserves are any funds a bank holds beyond this legally required minimum.

Q5: Why did the Federal Reserve eliminate reserve requirements?
A5: The Federal Reserve eliminated reserve requirements in 2020 because it shifted to an "ample-reserves" framework for implementing monetary policy. In this system, the Fed manages interest rates and liquidity primarily through other tools, making reserve requirements less crucial for maintaining control over the federal funds rate and overall liquidity.