Legal reserve

What Is Legal Reserve?

A legal reserve refers to the minimum amount of funds that commercial banks and other depository institutions are required by law to hold, rather than lend out. This mandate is typically set by the nation's central bank or other regulatory authorities and forms a core component of banking regulation, which falls under the broader category of monetary policy. The primary purpose of maintaining a legal reserve is to ensure the liquidity of the banking system, safeguard depositor funds, and serve as a tool for influencing the money supply and credit conditions within an economy.

History and Origin

The concept of requiring banks to hold reserves dates back centuries, even predating the establishment of formal central banking systems. Historically, these requirements were primarily intended to ensure banks had enough cash on hand to meet customer withdrawals, particularly during periods of financial stress or bank run events. For instance, in the United States, reserve requirements were a feature of the banking system long before the Federal Reserve System was created.²⁰

With the advent of modern central banks, the role of the legal reserve evolved. While still contributing to the stability of the financial system, reserve requirements also became an important instrument of monetary policy. Central banks could adjust these requirements to influence the amount of funds available for lending, thereby impacting interest rates and economic activity. However, in recent years, many central banks, including the U.S. Federal Reserve, have reduced or eliminated reserve requirements, shifting their monetary policy tools towards interest rate management and other measures. For example, the Federal Reserve reduced reserve requirement ratios to zero percent effective March 26, 2020, effectively eliminating them for all depository institutions in the U.S.¹⁹

Key Takeaways

• A legal reserve is the minimum percentage of deposits that banks must hold, mandated by the central bank.
• Its traditional purposes include ensuring bank liquidity and controlling the money supply.
• The actual funds can be held as vault cash or as balances at the central bank.
• Many central banks have reduced or eliminated reserve requirements in recent years, shifting to other monetary policy tools.
• Fulfilling legal reserve requirements is a crucial aspect of bank compliance and financial stability.

Formula and Calculation

While many central banks have eliminated or reduced legal reserve requirements to zero, traditionally, the legal reserve amount was calculated as a percentage of a bank's eligible deposits. This percentage is known as the reserve requirement ratio.

The general formula for calculating the required legal reserve is:

Variables:

• Deposits Subject to Reserve: This typically includes certain types of customer deposits, such as demand deposits (e.g., checking accounts) and sometimes time deposits (e.g., savings accounts or certificates of deposit), though classifications and exemptions vary by jurisdiction and historical period.¹⁶, ¹⁷, ¹⁸
• Reserve Requirement Ratio: The percentage set by the central bank.

For instance, prior to March 26, 2020, in the United States, reserve requirement ratios on net transaction accounts differed based on the amount, with a 10 percent ratio applied to balances above a certain threshold.¹⁵ The required reserves could be satisfied by holding vault cash or a balance at a Federal Reserve Bank.¹⁴

Interpreting the Legal Reserve

The interpretation of a legal reserve depends heavily on its context and the prevailing monetary policy framework. Historically, a higher legal reserve requirement meant that banks had less money available to lend, which could restrict the growth of the money supply and potentially lead to higher interest rates. Conversely, a lower requirement freed up more funds for lending, potentially stimulating economic growth.

In a system where legal reserves are actively used as a monetary policy tool, changes in the reserve requirement ratio signal the central bank's stance on monetary policy. An increase suggests a tightening of policy, while a decrease indicates an easing. However, in jurisdictions like the United States where the ratio has been set to zero, the legal reserve no longer serves its traditional function of constraining bank lending or managing liquidity on a day-to-day basis. Instead, other tools, such as interest on reserves and open market operations, are predominantly used to influence the money supply and credit conditions.

Hypothetical Example

Consider a hypothetical country, "Diversifia," where the central bank mandates a legal reserve requirement. Suppose Diversifia's Central Bank sets a reserve requirement ratio of 10% on all demand deposits.

Bank A, operating in Diversifia, has the following on its balance sheet:

• Demand Deposits: $100,000,000
• Time Deposits: $50,000,000

If only demand deposits are subject to the legal reserve requirement:

• Deposits Subject to Reserve = $100,000,000
• Reserve Requirement Ratio = 10%

The calculation for Bank A's legal reserve would be:

Legal Reserve = $100,000,000 × 0.10 = $10,000,000

This means Bank A must hold at least $10,000,000 in its vault or at the central bank as a legal reserve. The remaining $90,000,000 from demand deposits (plus the $50,000,000 in time deposits, if not reservable) would be available as loanable funds for the bank to lend out, subject to other regulatory considerations and its own risk management policies.

Practical Applications

Historically, legal reserves had several practical applications within financial systems:

• Monetary Policy Tool: Central banks utilized reserve requirements as a tool to expand or contract the money supply. By adjusting the ratio, they could influence bank lending capacity and, consequently, economic activity. ¹³For example, increasing the legal reserve ratio would limit the amount of money banks could lend, theoretically slowing inflation or cooling an overheated economy.
• Liquidity Management: Even if not the sole purpose, legal reserves provided a buffer of funds that banks could draw upon to meet unexpected withdrawals, thus contributing to the general liquidity and stability of individual banks and the overall banking sector.
  ¹²* Financial Sector Regulation: Legal reserves formed a part of the broader regulatory framework aimed at ensuring the soundness and safety of the financial system. The International Monetary Fund (IMF) has highlighted the importance of robust financial sector regulation for overall financial stability.
  ¹¹
  While the direct impact of legal reserves on monetary policy has diminished in many developed economies where ratios are now zero, the underlying principle of ensuring bank soundness remains paramount through other regulatory instruments like capital requirements and liquidity coverage ratios.

Limitations and Criticisms

Despite their historical importance, legal reserve requirements have faced several limitations and criticisms, leading many central banks to reduce or eliminate them.

One major criticism is that they can reduce bank profitability by requiring institutions to hold non-interest-earning assets, which can limit their ability to generate income through lending. ⁹, ¹⁰This "tax" on deposits could lead banks to seek riskier assets to compensate for the higher costs, or pass on the cost to customers through higher loan rates and lower deposit rates.
⁷, ⁸
Furthermore, the effectiveness of legal reserve requirements as a monetary policy tool in modern financial systems has been questioned. Innovations like "sweep accounts," which allow banks to shift funds overnight from reservable checking accounts to non-reservable savings accounts, significantly reduced the amount of deposits subject to reserve requirements, making them less binding for many institutions. ⁶This suggests that banks were already managing their cash flows based on business needs rather than strict regulatory obligations. Some argue that reserve requirements are no longer effective in controlling the money supply, especially when banks hold excess reserves. ⁴, ⁵Critics also point out that countries like Canada, England, and Australia operate successfully with no reserve requirements, indicating they are not universally necessary for bank soundness.
³
An academic paper published by Oxford University Press examines when reserve requirements are effective, noting that their traditional textbook impact on the money multiplier is less relevant if central banks target interest rates or exchange rates. ²The paper suggests that while higher reserve requirements can raise interest spreads and lower bank profits, their overall macroeconomic consequences are complex and depend heavily on the specific financial structure and central bank objectives.

Legal Reserve vs. Cash Reserve Ratio

While often used interchangeably or in similar contexts, "legal reserve" and "cash reserve ratio" (CRR) refer to related but distinct concepts.

Legal Reserve is the broader term for the minimum amount of funds, usually expressed as a percentage of deposits, that a financial institution is legally obligated to hold, rather than lend out. This obligation is set by a central bank or other regulatory authority. The legal reserve can be held in various forms, such as vault cash or balances with the central bank. It encompasses the general regulatory requirement.

The Cash Reserve Ratio (CRR) is a specific type of legal reserve. It refers explicitly to the portion of a bank's total deposits that it must maintain as liquid cash or as deposits with the central bank. It is essentially the percentage rate that determines the actual "cash" component of the legal reserve. The CRR is a precise metric within the broader legal reserve framework, indicating how much of a bank's liabilities must be held as unencumbered cash. In many countries, the CRR is the primary mechanism through which the legal reserve requirement is implemented.

The distinction is subtle but important: "legal reserve" refers to the mandate itself and the total required amount, while "cash reserve ratio" refers to the specific percentage that determines the cash component of that mandate.

FAQs

What happens if a bank fails to meet its legal reserve requirement?

If a bank fails to meet its legal reserve requirement, it may face penalties from the central bank, which could include fines or other disciplinary actions. In severe or persistent cases, it could also trigger increased regulatory scrutiny.

Do all countries have legal reserve requirements?

No, not all countries currently impose legal reserve requirements. As mentioned, the U.S. Federal Reserve reduced its reserve requirement ratio to zero, and other countries, such as Canada and the UK, also do not have active reserve requirements for their banks. ¹Many central banks have shifted to other tools, such as managing the interest paid on reserves, to implement monetary policy and ensure financial stability.

How does a legal reserve impact lending?

Traditionally, a legal reserve requirement directly impacted a bank's lending capacity. The higher the ratio, the less money a bank could lend out from its deposits. This theoretically reduced the supply of available credit, potentially leading to higher lending rates. Conversely, a lower ratio freed up more funds for banks to lend. However, in modern banking systems, particularly where reserve requirements are minimal or zero, their direct impact on lending is significantly diminished.

Is the legal reserve the same as bank capital?

No, the legal reserve is not the same as bank capital. Legal reserves are specific funds that banks must hold to meet liquidity requirements or as part of monetary policy. Bank capital refers to the equity and other long-term funding sources that provide a cushion against losses. While both are regulatory requirements aimed at ensuring bank solvency and stability, they serve different functions. Capital absorbs losses, while reserves historically addressed liquidity.