Reserve requirements are
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a centra ...
regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the
commercial bank's reserve, is generally determined by the central bank on the basis of a specified proportion of
deposit liabilities of the bank. This rate is commonly referred to as the reserve ratio. Though the definitions vary, the commercial bank's reserves normally consist of
cash
In economics, cash is money in the physical form of currency, such as banknotes and coins.
In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-immed ...
held by the bank and stored physically in the
bank vault (vault cash), plus the amount of the bank's balance in that bank's account with the central bank. A bank is at liberty to hold in reserve sums above this minimum requirement, commonly referred to as ''
excess reserves
Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank.
In the United States, bank reserves for a commercial bank are represented by its cash holdings and any credit balance in an accou ...
''.
The reserve ratio is sometimes used by a country’s
monetary authority
In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation, interest rates, real GDP or unemployment rate. With its monetary tools, a mon ...
as a tool in
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often ...
, to influence the country's
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
by limiting or expanding the amount of lending by the banks. Monetary authorities increase the reserve requirement only after careful consideration because an abrupt change may cause liquidity problems for banks with low excess reserves; they generally prefer to use
open market operations (buying and selling government-issued
bonds) to implement their monetary policy. In the United States and many other countries (except Brazil, China, India, Russia), reserve requirements are generally not altered frequently in implementing a country's monetary policy because of the short-term disruptive effect on financial markets.
Policy objective
One of the critical functions of a country's central bank is to maintain public confidence in the banking system, because under the
fractional-reserve banking
Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserv ...
system in operation in most countries worldwide banks are not expected to hold cash to cover all deposits liabilities in full. One of the mechanisms used by most central banks to further this objective is to set a reserve requirement to ensure that banks have, in normal circumstances, sufficient cash on hand in the event that large deposits are withdrawn, which may precipitate a
bank run
A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks no ...
. The central bank in some jurisdictions, such as the European Union, does not require reserves to be held during the day, while in others, such as the United States, the central bank does not set a reserve requirement at all.
Bank deposits are usually of a relatively short-term duration, and may be “at call”, while loans made by banks tend to be longer-term, resulting in a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. The reserves only provide
liquidity
Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include:
* Market liquidity, the ease with which an asset can be sold
* Accounting liquidity, the ability to meet cash obligations when due
* Liqu ...
to cover withdrawals within the normal pattern. Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that the reserves will be sufficient to meet the demand for cash. However, banks routinely find themselves in a shortfall situation or may experience an unexpected
bank run
A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks no ...
, when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may routinely borrow short-term funds in the
interbank lending market
The interbank lending market is a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being over day. Such loans are made at the interbank rate (also call ...
from banks with a surplus. In exceptional situations, the central bank may provide funds to cover the short-term shortfall as
lender of last resort
A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market when other faci ...
.
When the bank liquidity problem exceeds the central bank’s lender of last resort resources, as happened during the
global financial crisis
Global means of or referring to a globe and may also refer to:
Entertainment
* ''Global'' (Paul van Dyk album), 2003
* ''Global'' (Bunji Garlin album), 2007
* ''Global'' (Humanoid album), 1989
* ''Global'' (Todd Rundgren album), 2015
* Bruno ...
of 2007-2008, the government may try to restore confidence in the banking system, for example, by providing
government guarantees.
Effects on money supply
Textbook view
Many textbooks describe a system in which reserve requirements can act as a tool of a country’s monetary policy though these bear little resemblance to reality and many central banks impose no such requirements. The commonly assumed requirement is 10% though almost no central bank and no major central bank imposes such a ratio requirement.
With higher reserve requirements, there would be less funds available to banks for lending. Under this view, the
money multiplier compounds the effect of bank lending on the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
. The multiplier effect on the money supply is governed by the following formulas:
:
: definitional relationship between monetary base ''MB'' (bank reserves plus currency held by the non-bank public) and the narrowly defined
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
,
,
:
: derived formula for the
money multiplier ''m'', the factor by which lending and re-lending leads
to be a multiple of the monetary base:
where notationally,
:
the currency ratio: the ratio of the public's holdings of currency (undeposited cash) to the public's holdings of
demand deposit
Demand deposits or checkbook money are funds held in demand accounts in commercial banks. These account balances are usually considered money and form the greater part of the narrowly defined money supply of a country. Simply put, these are depo ...
s; and
:
the total reserve ratio (the ratio of legally required plus non-required reserve holdings of banks to demand deposit liabilities of banks).
This limit on the money supply does not apply in the real world.
Endogenous money view
Central banks dispute the money multiplier theory of the reserve requirement and instead consider money as endogenous. See
endogenous money.
Jaromir Benes and Michael Kumhof of the IMF Research Department report that the "deposit multiplier" of the undergraduate economics textbook, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through bank lending, turns the actual operation of the
monetary transmission mechanism on its head. Benes and Kumhof assert that in most cases where banks ask for replenishment of depleted reserves, the central bank obliges.
Under this view, reserves therefore impose no constraints, as the deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth. Under this theory, private banks almost fully control the money creation process.
Required reserves
United States
The Board of Governors of the
Federal Reserve System
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
sets reserve requirements (“liquidity ratio”) based on categories of deposit liabilities ("Net Transaction Accounts" or "NTAs") of depository institutions, such as
commercial bank
A commercial bank is a financial institution which accepts deposits from the public and gives loans for the purposes of consumption and investment to make profit.
It can also refer to a bank, or a division of a large bank, which deals with co ...
s including U.S. branches of a foreign bank,
savings and loan association
A savings and loan association (S&L), or thrift institution, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans. The terms "S&L" or "thrift" are mainly used in the United States; si ...
,
savings bank
A savings bank is a financial institution whose primary purpose is accepting savings deposits and paying interest on those deposits.
They originated in Europe during the 18th century with the aim of providing access to savings products to ...
, and
credit union
A credit union, a type of financial institution similar to a commercial bank, is a member-owned nonprofit financial cooperative. Credit unions generally provide services to members similar to retail banks, including deposit accounts, provision ...
. The deposit liability categories currently subject to reserve requirements are mainly checking accounts, with no reserve requirement on savings accounts and
time deposit accounts of individuals. The total amount of all NTAs held by customers with U.S. depository institutions, plus the U.S. paper currency and coin currency held by the nonbank public, is called
M1.
As of March 2020, the reserve requirement for all deposit institutions was set to 0% of eligible deposits. The Board previously set a zero reserve requirement for banks with eligible deposits up to , 3% for banks up to , and 10% thereafter. The removal of reserve requirements followed the Federal Reserve's shift to an "ample-reserves" system, in which the Federal Reserve Banks pay member banks interest on excess reserves held by them.
Under the
International Banking Act of 1978, the same reserve ratios apply to branches of foreign banks operating in the United States.
China
The
People's Bank of China
The People's Bank of China (officially PBC or informally PBOC; ) is the central bank of the People's Republic of China, responsible for carrying out monetary policy and regulation of financial institutions in mainland China, as determined by ...
uses changes in the reserve requirement as an inflation-fighting tool, and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010.
Countries and districts without reserve requirements
Canada, the UK, New Zealand, Australia, Sweden and Hong Kong
have no reserve requirements.
This does not mean that banks can—even in theory—create money without limit. On the contrary, banks are constrained by
capital requirements, which are arguably more important than reserve requirements even in countries that have reserve requirements.
A commercial bank's overnight reserves are not permitted to become ''negative''. The central bank will step in to lend a bank funds if necessary so that this does not happen. Historically, a central bank might have run out of reserves to lend to banks with liquidity problems and so had to suspend redemptions, but this can no longer happen to modern central banks because of the end of the
gold standard
A gold standard is a Backed currency, monetary system in which the standard economics, economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the ...
worldwide, which means that all nations use a
fiat currency
Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometim ...
.
A zero reserve requirement cannot be explained by a theory that holds that monetary policy works by varying the quantity of money using the reserve requirement.
Even in the United States, which retained formal reserve requirements until 2020, the notion of controlling the money supply by targeting the quantity of base money fell out of favor many years ago, and now the pragmatic explanation of monetary policy refers to targeting the ''interest rate'' to control the broad money supply. (See also
Regulation D (FRB).)
United Kingdom
In the
United Kingdom
The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the European mainland, continental mainland. It comprises England, Scotlan ...
, commercial banks are called
clearing banks Clearing bank may refer to:
* Clearing (finance), a bank that participates in the system to clear (finalize) financial transactions
*Cheque and Credit Clearing Company
The Cheque and Credit Clearing Company Limited (C&CCC) is a UK membership-ba ...
with direct access to the clearing system.
The
Bank of England, the central bank for the United Kingdom, previously set a voluntary reserve ratio, and not a minimum reserve requirement. In theory, this meant that commercial banks could retain zero reserves. The average cash reserve ratio across the entire United Kingdom banking system, though, was higher during that period, at about 0.15% .
From 1971 to 1980, the commercial banks all agreed to a reserve ratio of 1.5%. In 1981 this requirement was abolished.
From 1981 to 2009, each commercial bank set out its own monthly voluntary reserve target in a contract with the Bank of England. Both shortfalls and excesses of reserves relative to the commercial bank's own target over an averaging period of one day
would result in a charge, incentivising the commercial bank to stay near its target, a system known as ''reserves averaging''.
Upon the parallel introduction of quantitative easing and
interest on excess reserves in 2009, banks were no longer required to set out a target, and so were no longer penalised for holding excess reserves; indeed, they were proportionally compensated for holding all their reserves at the Bank Rate (the Bank of England now uses the same interest rate for its bank rate, its deposit rate and its interest rate target). In the absence of an agreed target, the concept of excess reserves does not really apply to the Bank of England any longer, so it is technically incorrect to call its new policy "interest on excess reserves".
Canada
Canada abolished its reserve requirement in 1992.
Australia
Australia abolished "statutory reserve deposits" in 1988, which were replaced with 1% non-callable deposits.
[
]
United States
The United States
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territor ...
removed reserve requirements for nonpersonal time deposits and eurocurrency liabilities on Dec 27, 1990 and for net transaction accounts on March 27, 2020.
Reserve requirements by country
The reserve ratios set in each country and district vary.[Lecture 8, Slide 4: "Central Banking and the Money Supply" from the presentation ]
Monetary Macroeconomics
' by Dr
University of Zurich
The University of Zürich (UZH, german: Universität Zürich) is a public research university located in the city of Zürich, Switzerland. It is the largest university in Switzerland, with its 28,000 enrolled students. It was founded in 1833 ...
, based on 2003 survey of CBC participants at the Study Center Gerzensee The following list is non-exhaustive:
See also
* Bank regulation
Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom the ...
* Basel accords
* Capital requirement
* Capital adequacy ratio
* Criticism of the Federal Reserve
* Excess reserves
Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank.
In the United States, bank reserves for a commercial bank are represented by its cash holdings and any credit balance in an accou ...
* Financial repression
Financial repression comprises "policies that result in savers earning returns below the rate of inflation" to allow banks to "provide cheap loans to companies and governments, reducing the burden of repayments." It can be particularly effective a ...
* Fractional-reserve banking
Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserv ...
* Full-reserve banking
Full-reserve banking (also known as 100% reserve banking, narrow banking, or sovereign money system) is a system of banking where banks do not lend demand deposits and instead, only lend from time deposits. It differs from fractional-reserve bank ...
* Great Contraction
* Islamic banking
Islamic banking, Islamic finance ( ar, مصرفية إسلامية), or Sharia-compliant finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic econom ...
* Monetary policy of central banks
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
* Money creation
Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region,Such as the Eurozone or ECCAS is increased. In most modern economies, money creation is controlled by the central bank ...
* Money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
* Negative interest on excess reserves
* Statutory liquidity ratio
In India, the Statutory liquidity ratio (SLR) is the Government term for the reserve requirement that commercial banks are required to maintain in the form of cash, gold reserves,Govt. bonds and other Reserve Bank of India (RBI)- approved securit ...
* Tier 1 capital
* Tier 2 capital
References
External links
Title 12 of the Code of Federal Regulations (12CFR) Part 204--Reserve Requirements of Depository Institutions (Regulation D)
(See Section §204.4 for current reserve requirements.)
(May 2007)
* ttp://www.islamic-finance.com/item113_f.htm Don't mention the reserve ratio
{{DEFAULTSORT:Reserve Requirement
Banking
Monetary policy
Financial ratios
Financial economics
Capital requirement