Reserve requirements are
central bank
A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the mo ...
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 cash reserve ratio or shortened as 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 book-keeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-i ...
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 accoun ...
''.
In some areas such as the euro area and the UK, tightening of reserve requirements in the home country is found to be associated with higher lending by foreign branches. For this reason, the reserve ratio is sometimes used by a country’s
monetary authority
A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monet ...
as a tool in
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability (normally interpreted as a low and stable rat ...
, to influence the country's
money supply
In macroeconomics, money supply (or money stock) refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation (i ...
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 other monetary policy instruments to implement their monetary policy. In many countries (except
Brazil
Brazil, officially the Federative Republic of Brazil, is the largest country in South America. It is the world's List of countries and dependencies by area, fifth-largest country by area and the List of countries and dependencies by population ...
,
China
China, officially the People's Republic of China (PRC), is a country in East Asia. With population of China, a population exceeding 1.4 billion, it is the list of countries by population (United Nations), second-most populous country after ...
,
India
India, officially the Republic of India, is a country in South Asia. It is the List of countries and dependencies by area, seventh-largest country by area; the List of countries by population (United Nations), most populous country since ...
,
Russia
Russia, or the Russian Federation, is a country spanning Eastern Europe and North Asia. It is the list of countries and dependencies by area, largest country in the world, and extends across Time in Russia, eleven time zones, sharing Borders ...
), reserve requirements are generally not altered frequently in implementing a country's monetary policy because of the short-term disruptive effect on financial markets. In several countries, including the
United States
The United States of America (USA), also known as the United States (U.S.) or America, is a country primarily located in North America. It is a federal republic of 50 U.S. state, states and a federal capital district, Washington, D.C. The 48 ...
, there are today zero reserve requirements.
Policy objective
One of the critical functions of a country's central bank is to maintain public confidence in the banking system, as under a
fractional-reserve banking
Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to ...
system 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 Client (business), clients withdraw their money from a bank, because they believe Bank failure, the bank may fail in the near future. In other words, it is when, in a fractional-reserve banking sys ...
. 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
In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quic ...
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 may find themselves in a shortfall situation or experience a
bank run
A bank run or run on the bank occurs when many Client (business), clients withdraw their money from a bank, because they believe Bank failure, the bank may fail in the near future. In other words, it is when, in a fractional-reserve banking sys ...
, when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may 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 overnight. Such loans are made at the interbank rate (also cal ...
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
In public finance, a lender of last resort (LOLR) is a financial entity, generally a central bank, that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank ...
.
If the bank's liquidity problem exceeds the central bank's desire to continue as "lender of last resort", as happened during the
2008 financial crisis
The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...
, 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
In monetary economics, the money multiplier is the ratio of the money supply to the monetary base (i.e. central bank money).
In some simplified expositions, the monetary multiplier is presented as simply the reciprocal of the reserve ratio, i ...
compounds the effect of bank lending on the
money supply
In macroeconomics, money supply (or money stock) refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation (i ...
. 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, money supply (or money stock) refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation (i ...
,
,
:
: derived formula for the
money multiplier
In monetary economics, the money multiplier is the ratio of the money supply to the monetary base (i.e. central bank money).
In some simplified expositions, the monetary multiplier is presented as simply the reciprocal of the reserve ratio, i ...
''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 dep ...
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
Endogenous money is an economy’s supply of money that is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously (autonomously) by an external authority such as a central bank.
...
.
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
The monetary transmission mechanism is the process by which monetary policy decisions affect the broader macroeconomy through multiple channels including asset prices, money markets, and general economic conditions. Such decisions are implemente ...
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
China
The People's Bank of China
The People's Bank of China (officially PBC and unofficially PBOC) is the central bank of the People's Republic of China. It is responsible for carrying out monetary policy as determined by the ''PRC People's Bank Law'' and the ''PRC Commercia ...
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.
India
The Reserve Bank of India
Reserve Bank of India, abbreviated as RBI, is the central bank of the Republic of India, and regulatory body responsible for regulation of the Indian banking system and Indian rupee, Indian currency. Owned by the Ministry of Finance (India), Min ...
uses changes in the CRR as a liquidity management tool, hiked it alongside SLR to navigate the 2008 financial crisis
The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...
. RBI introduced and withdrew Incremental - Cash reserve ratio I-CRR over and above CRR for managing liquidity.
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
A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital a ...
, 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 is a type of government-issued currency that is not backed by a precious metal, such as gold or silver, nor by any other tangible asset or commodity. Fiat currency is typically designated by the issuing government to be legal tender, ...
.
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 Northwestern Europe, off the coast of European mainland, the continental mainland. It comprises England, Scotlan ...
, commercial banks are called clearing banks with direct access to the clearing system.
The Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694 to act as the Kingdom of England, English Government's banker and debt manager, and still one ...
, 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, commercial banks 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
Australia, officially the Commonwealth of Australia, is a country comprising mainland Australia, the mainland of the Australia (continent), Australian continent, the island of Tasmania and list of islands of Australia, numerous smaller isl ...
abolished "statutory reserve deposits" in 1988, which were replaced with 1% non-callable deposits.[
]
United States
In the Thomas Amendment to the Agricultural Adjustment Act
The Agricultural Adjustment Act (AAA) was a United States federal law of the New Deal era designed to boost agricultural prices by reducing surpluses. The government bought livestock for slaughter and paid farmers Subsidy, subsidies not to plant ...
of 1933, the Federal Reserve was granted the authority to set reserve requirements jointly with the president as one of several provisions that sought to mitigate or prevent deflation. The power was granted to the Federal Reserve, without presidential consent, in the Banking Act of 1935. Under the International Banking Act of 1978, the same reserve ratios would apply to branches of foreign banks operating in the United States.
The United States removed reserve requirements for nonpersonal time deposits and eurocurrency liabilities on December 27, 1990 and for net transaction accounts on March 27, 2020, thus eliminating reserve requirements altogether. Before that, 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. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of ...
used to set 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 that accepts deposits from the public and gives loans for the purposes of consumption and investment to make a profit.
It can also refer to a bank or a division of a larger bank that deals with whol ...
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. While the terms "S&L" and "thrift" are mainly used in the United States, ...
, savings bank
A savings bank is a financial institution that is not run on a profit-maximizing basis, and whose original or primary purpose is collecting deposits on savings accounts that are invested on a low-risk basis and receive interest. Savings banks ha ...
, and credit union
A credit union is a member-owned nonprofit organization, nonprofit cooperative financial institution. They may offer financial services equivalent to those of commercial banks, such as share accounts (savings accounts), share draft accounts (che ...
. For a time, checking accounts were subject to reserve requirements, whereas there was no reserve requirement on savings accounts and time deposit
A time deposit or term deposit (also known as a certificate of deposit in the United States, and as a guaranteed investment certificate in Canada) is a deposit in a financial institution with a specific maturity date or a period to maturity, c ...
accounts of individuals. The Board for some time set a zero reserve requirement for banks with eligible deposits up to , 3% for banks up to , and 10% thereafter. The total 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.
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.
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 Zurich (UZH, ) is a public university, public research university in Zurich, Switzerland. It is the largest university in Switzerland, with its 28,000 enrolled students. It was founded in 1833 from the existing colleges of the ...
, based on 2003 survey of CBC participants at the Study Center Gerzensee The following list is non-exhaustive:
See also
* Bank regulation
Banking regulation and supervision refers to a form of financial regulation which subjects banks to certain requirements, restrictions and guidelines, enforced by a financial regulatory authority generally referred to as banking supervisor, wit ...
* Basel accords
* Capital requirement
A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital ...
* Capital adequacy ratio
Capital Adequacy Ratio (CAR) also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies ...
* 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 accoun ...
* 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 in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to ...
* Full-reserve banking
Full-reserve banking (also known as 100% reserve banking, or sovereign money system) is a system of banking where banks do not lend Demand deposit, demand deposits and instead only lend from time deposits. It differs from fractional-reserve bankin ...
* Great Contraction
* Islamic banking
Islamic banking, Islamic finance ( ''masrifiyya 'islamia''), or Sharia-compliant finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic economics. Some ...
* Monetary policy of central banks
Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability (normally interpreted as a low and stable rat ...
* Money creation
Money creation, or money issuance, is the process by which the money supply of a country, or an economic or monetary region,Such as the Eurozone or ECCAS is increased. In most modern economies, money is created by both central banks and comm ...
* Money supply
In macroeconomics, money supply (or money stock) refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation (i ...
* Negative interest on excess reserves
Negative may refer to:
Science and mathematics
* Negative number
* Minus sign (−), the mathematical symbol
* Negative mass
* Negative energy
* Negative charge, one of the two types of electric charge
* Negative (electrical polarity), in e ...
* 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 secur ...
* Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.By definition of Bank for International Settlements. It is composed of ''core capital'', which consists primarily of common stock and disclosed ...
* 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