Holds and reserves

What Are Reserve Requirements?

Reserve requirements represent the minimum amount of funds that depository institutions must hold in reserve, either in their vaults or at a central bank, against customer deposits. These requirements are a key component of banking regulation and monetary policy, designed to ensure banks maintain sufficient liquidity to meet unexpected withdrawals and maintain stability within the financial system. The concept is central to fractional-reserve banking, where banks lend out most of the funds deposited by customers, retaining only a fraction as reserves.

History and Origin

The concept of reserve requirements has deep roots in banking history, largely evolving in response to periods of financial instability. Before centralized banking systems, individual banks often held reserves based on their own risk assessments. However, widespread financial panics and bank run events demonstrated the need for a more structured approach. For instance, during the Great Depression, a wave of banking panics saw large numbers of anxious people withdrawing their deposits, forcing banks to liquidate loans and leading to widespread failures²⁵,. This crisis underscored the vulnerability of a banking system without robust reserve protections and contributed to the establishment of more formal reserve requirements and deposit insurance schemes globally²⁴.

In the United States, the Federal Reserve Act of 1913 established the Federal Reserve System, granting it the authority to impose reserve requirements on member banks²³,. These requirements evolved over time, with ratios differing based on the amount of net transaction accounts at the depository institution²². However, in response to the COVID-19 pandemic, the Federal Reserve reduced reserve requirement ratios to zero percent effective March 26, 2020, effectively eliminating them for all depository institutions²¹,. This move aimed to provide additional economic growth and liquidity to the financial system during a period of stress,²⁰.

Key Takeaways

• Reserve requirements dictate the minimum cash or equivalent assets banks must hold against customer deposits.
• They serve as a tool for central bank to influence the nation's money supply and manage interest rates.
• Historically, these requirements have played a crucial role in preventing bank runs and maintaining financial stability.
• While once a primary tool, their application has changed significantly, with some major economies, like the United States, reducing them to zero.
• Global frameworks, such as Basel III, introduce modern liquidity standards that complement or supersede traditional reserve requirements.

Formula and Calculation

Historically, the calculation of reserve requirements was straightforward, involving a direct percentage of a bank's deposits.

• Required Reserves: The absolute amount of funds a bank must hold.
• Reserve Requirement Ratio: The percentage set by the central bank.
• Total Deposits: The sum of eligible customer deposits at the depository institutions.

For example, if a bank had $100 million in deposits and the reserve requirement ratio was 10%, the bank would be required to hold $10 million in reserves. The remaining $90 million would be available for lending or other investment activities. However, as noted, the effective reserve requirement in the U.S. has been reduced to zero, making this calculation less directly applicable for U.S. banks in a regulatory sense as of March 2020¹⁹,.

Interpreting Reserve Requirements

The interpretation of reserve requirements primarily depends on the prevailing monetary policy stance of a central bank. When a central bank increases reserve requirements, it effectively reduces the amount of funds available for banks to lend, thus tightening credit conditions and potentially slowing the growth of the money supply. Conversely, lowering reserve requirements can free up funds for lending, stimulating economic growth and potentially lowering interest rates.

While the explicit ratio may be zero in some jurisdictions, the underlying principle of maintaining adequate reserves remains crucial. Banks still manage significant balances with the central bank, which are influenced by factors such as regulatory liquidity standards and internal risk management. These balances, often visible on the central bank's balance sheet, represent a significant portion of the banking system's overall assets,¹⁸.

Hypothetical Example

Consider a hypothetical country, "Diversifica," where the central bank mandates a 5% reserve requirement for all its depository institutions.

Bank Alpha receives $200 million in new customer deposits.

1. Calculate Required Reserves: Bank Alpha must hold 5% of $200 million as reserves.
   Required Reserves = 0.05 * $200,000,000 = $10,000,000
2. Determine Excess Reserves: The amount available for lending.
   Excess Reserves = Total Deposits - Required Reserves = $200,000,000 - $10,000,000 = $190,000,000

In this scenario, Bank Alpha is permitted to lend out up to $190 million, while $10 million must be held as non-interest-earning reserves. This ensures that a portion of the deposits is readily available, contributing to the bank's liquidity.

Practical Applications

Reserve requirements, or their modern equivalents, have several practical applications in finance and economics:

• Monetary Policy Tool: Historically, adjusting the reserve requirement was a potent tool for a central bank to influence the money supply and credit conditions. A higher requirement would reduce the money multiplier effect, while a lower one would expand it¹⁷. While less direct today in some countries, this function remains conceptually important in academic discussions of monetary policy.
• Financial Stability: Even with explicit reserve requirements at zero, the underlying principle of holding sufficient liquid assets remains paramount for preventing bank run and ensuring the stability of individual banks and the broader financial system.
• International Standards: Global regulatory frameworks, such as Basel III, introduce international standards for liquidity risk management, including the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). These ratios require banks to hold sufficient high-quality liquid assets to survive stress scenarios, effectively acting as a modern form of reserve requirement for liquidity purposes¹⁶,¹⁵. The LCR, for example, requires banks to hold enough high-quality liquid assets to cover their total net cash outflows over a 30-day stressed scenario,¹⁴. The Bank for International Settlements (BIS) has provided extensive guidance on these liquidity standards globally¹³.
• Central Bank Operations: The balance sheet of a central bank reflects the aggregate level of reserves held by commercial banks as liabilities,¹². Changes in these balances are closely monitored by financial market participants as they provide insight into the central bank's liquidity management and overall stance of open market operations¹¹.

Limitations and Criticisms

Despite their historical importance, traditional reserve requirements have faced several limitations and criticisms:

• Blunt Instrument: Changing reserve requirements can have a significant and often unpredictable impact on the banking system, making it a less precise tool compared to other monetary policy instruments like open market operations or adjusting interest rates. Even minor changes could create substantial shifts in the availability of funds for lending, potentially causing market disruptions.
• Cost to Banks: Holding non-interest-earning reserves can be a financial burden for depository institutions, especially when reserve ratios are high or market interest rates are elevated. This can reduce a bank's profitability and its incentive to lend.
• Financial Innovation: The rise of financial innovations, such as sweep accounts, where funds are automatically shifted between checking and savings accounts, made it easier for banks to circumvent reserve requirements, thereby diminishing their effectiveness¹⁰. This innovation allowed banks to manage their cash flows more in accordance with business needs rather than regulatory obligations⁹.
• Shifting Focus to Other Tools: Many central banks, including the Federal Reserve, have increasingly relied on other tools, such as the federal funds rate target and quantitative easing (large-scale asset purchases), to manage the [money supply](https://diversification.com/term/money supply) and influence the economy. The Federal Reserve's decision to set reserve requirements to zero is a testament to this shift, recognizing that ample reserves are already present in the system due to previous asset purchase programs⁸,.

Reserve Requirements vs. Liquidity

While often related, "reserve requirements" and "liquidity" refer to distinct but interconnected concepts in banking and financial crisis prevention.

• Reserve Requirements: Traditionally a regulatory mandate from a central bank dictating the minimum percentage of deposits that banks must hold as non-interest-earning reserves. Their primary goal was to control the money supply and provide a buffer against immediate withdrawals. As discussed, many explicit reserve requirements have been reduced or eliminated in modern financial systems.
• Liquidity: Refers to the ease with which an asset can be converted into cash without significant loss of value. In banking, liquidity management is a bank's ongoing process of ensuring it has sufficient cash or easily convertible assets to meet its short-term obligations and funding needs, regardless of regulatory mandates. This includes managing cash flows, access to short-term funding markets, and holding high-quality liquid assets (HQLA). Post-financial crisis, frameworks like Basel III have introduced stringent liquidity risk standards (e.g., LCR, NSFR) that compel banks to maintain robust liquidity buffers, which are broader in scope than traditional reserve requirements and focus on a bank's ability to withstand stress scenarios,⁷,⁶.

In essence, while reserve requirements once directly contributed to a bank's regulatory liquidity, the modern focus is on comprehensive liquidity risk management and capital requirements that assess a bank's overall ability to meet its obligations, going beyond a simple percentage of deposits.

FAQs

Q: Why did the Federal Reserve reduce reserve requirements to zero?

A: The Federal Reserve reduced reserve requirements to zero in March 2020 to provide additional liquidity to the banking system and support the flow of credit to households and businesses during the economic disruption caused by the COVID-19 pandemic⁵,. This move also reflected the Fed's shift towards managing interest rates primarily through other tools, such as the federal funds rate and open market operations, as opposed to direct control over bank reserves⁴.

Q: Do banks still hold reserves if the requirement is zero?

A: Yes, depository institutions still hold substantial balances with the central bank, even with a zero reserve requirement. These balances are often held for operational purposes, such as clearing payments, and to meet internal liquidity management needs and international regulatory standards like Basel III's Liquidity Coverage Ratio³,². The aggregate level of these balances is publicly disclosed on the Federal Reserve's balance sheet.

Q: What is the difference between required reserves and excess reserves?

A: Required reserves are the minimum amount of funds a bank is legally mandated to hold, traditionally a percentage of its deposits, set by the central bank. Excess reserves are any reserves held by a bank above the required amount. When reserve requirements are zero, all reserves held are technically excess reserves. These excess reserves can be used for lending, investment, or to meet unexpected withdrawals¹.