What is Bank Reserve?
Bank Reserves refer to the minimum liquidity reserves that every bank is required to maintain to make sure they never run out of cash in case the customer demands the withdrawal of the deposits kept with the bank.
#1 – Required Reserve
The required reserve is the minimum funds that banks must hold to meet their deposit liabilities. The Fed has the authority to make changes from time to time in the required reserve ratio percentage.
The Fed has updated its required reserve target ratio, which is applicable from the effective date January 17, 2019. The updated limits are as follows:
As per the latest requirements, all the banks having deposit liabilities valuing more than the US $ 16.30 million but less than the US $ 124.20 million must keep 3% of deposits as required reserve and the banks with deposit liabilities of more than the US $ 124.20 million must maintain a required reserve equal to 10% of deposit values.
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Further, while calculating the amount of required reserve, the banks consider the net transaction accounts, that means they do not consider the funds due from other banks or transaction that are still outstanding.
#2 – Excess Reserve
The excess reserve is the cash required to keep in the vault over the minimum required reserve. Usually, the banks keep the excess reserve balance at lower levels and lend out the money instead of keeping it in vaults. This is mainly because banks can earn higher returns by lending the funds as compared to the rate of interest offered by the Fed. In the past, the incentives on maintaining the excess reserve balances were very low or near to zero. However, the excess reserve balance can pile up during the crisis scenarios.
Monetary Policy and Bank Reserves Requirements
- If the Fed raises the required reserve ratio and excess reserve target ratio, it will increase the amount of funds to be kept in cash or in the vault for all the banks. In such a scenario, the banks will be left with less money to lend out.
- During the financial crisis, similar to the financial crisis that happened in 2008, the Fed reduced the reserve target ratios to the lowest possible ceiling in order to stimulate the lending and to initiate economic recovery. However, in 2008, even after the lowest reserve requirements, the banks were not ready to lend due to a high volume of bad debts, and they want to utilize the available cash realized from the reserve holding toward the writing off the bad debts.
- During the 2008 crisis, the aggregate of the excess reserve of all the banks shoots up to the US $ 1.25 trillion (as reported in the data of Federal Reserve Statistical Release H.3) and the liability side of Fed’s Balance Sheet increase due to increased reserve balances.
- Instead of allowing the banks to use the funds to write off the bad debt, the fed made a change in its policy in October 2008 and started paying interest on the reserve funds. The interest rate offered was fluctuating with the monetary policy. This unconventional move allowed the Fed to take control of the money market securities and short term interest rates.
Interest Rate on Bank Reserves
The interest rate on required reserves (IORR) and the Interest rate on Excess reserve (IOER) are determined by the Fed. These interest rate gets updated each business day at 4:30 pm EST with the interest rate for the next business day.
The latest published interest rate is as follows:
Impact of Inflation
During Inflation, the demand for the goods and services surpass the available supply at current prices. This demand-supply gap leads to an increase in prices and causes inflation. In order to deal with the scenario, the Fed begins to pay higher interest on the excess reserve, which affects the lending growth as a guard against inflationary pressure.
When a Fed raises the interest rate on excess reserves, the banks become more willing to keep the cash in the vault instead of lending it out, which affects the purchasing power of the consumers and hence the recovery beings to establish equilibrium.
However, when the economy goes through the problem of deflation (i.e., when the supply of the goods and services produced is higher than the demand), the fed reduces the interest rate almost to zero. This encourages the lending process resulting in an increase in the purchasing power of the end-users.
Bank reserves are the minimum amount of funds held by the banks in cash or vault to ensure regulatory compliance with the federal reserve bank. The key purpose is to regulate the banking procedure and to make sure that banks will not go short of funds if any demand liability arises.
This has been a guide to Bank Reserve and its definition. Here we discuss classification (Required Reserve and Excess Reserve) and the impact of inflation on bank reserves requirements. You can more about finance from the following articles –