What are bank reserves?
Bank reserves are the cash minimums that must be held by financial institutions in order to meet the requirements of the central bank. The bank cannot lend money but must keep it in the safe, on site or at the central bank, in order to meet any large and unexpected demand for withdrawals.
In the United States, the Federal Reserve dictates the amount of cash reserves each bank must maintain.
Operation of bank reserves
Bank reserves are essentially an antidote to panic. The Federal Reserve forces banks to keep a certain amount of money in reserve so that they never run out and must refuse a customer’s withdrawal, which can trigger a bank transfer.
Key points to remember
- Bank reserves are the minimum amounts of liquidity that banks must keep in case of unexpected demand.
- Excess reserves are the extra cash that a bank keeps in hand and refuses to lend.
- These excess reserves tend to increase in bad times and decrease in good times.
Bank reserves are divided into the required reserve and the excess reserve. The reserve required is the minimum amount at the cash desk.
The excess reserve is any cash amount greater than the minimum required that the bank holds in the safe rather than using it as a loan. Banks generally have little incentive to maintain excess reserves, as cash yields nothing and may even lose value over time due to inflation. Thus, banks normally minimize their excess reserves and lend money to customers rather than keeping it in their vaults.
Bank reserves decrease during periods of economic expansion and increase during recessions. In other words, at the right times, businesses and consumers borrow more and spend more. During recessions, they cannot or do not want to take on more debt.
The required bank reserve follows a formula established by Federal Reserve Board regulations which is based on the amount deposited in the net transaction accounts. These include demand deposits, automatic transfer accounts and shared account projects. Net transactions are calculated as the total amount in transaction accounts minus funds owed from other banks and minus cash being collected.
The required reserve ratio can also be used as a tool for implementing monetary policies. With this ratio, a central bank can influence the amount of funds available for borrowing.
In late 2008, the Federal Reserve began paying interest to banks for reserve and excess reserves to inject more liquidity into the US economy. This has overturned conventional wisdom that banks prefer to lend money rather than keeping it in the safe.
The required bank reserves are determined by the Federal Reserve for each bank based on its net transactions.
Impact of the 2008 crisis
As noted, banks generally maintain their excess reserves at minimum levels. However, the interest rate at which banks could lend money fell sharply after December 2008, when the Federal Reserve attempted to revive the economy by cutting interest rates. Around the same time, the Federal Reserve began to pay interest to banks on their cash reserves.
The banks took the money injected by the Federal Reserve and kept it as excess reserves rather than lending it. They were earning a low but essentially risk-free interest rate rather than lending it for a slightly higher but riskier return.
For this reason, the amount of excess reserves increased after 2008, despite an unchanged minimum reserve ratio.