Reserve Requirement Definition
Reserve Requirement, also known as the cash reserve ratio, is the liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.
It is mandated by central banks around the world for their member banks in order to regulate safety cash held by the banks. This cash reserve serves many different purposes in different economies. The Central bank of the United States is the Federal Bank which holds authority on this requirement in the United States. Similarly, the People’s Bank of China does a similar function for Chinese banks.
Components of Reserve Requirement
Reserve Requirement is a function of Net Demand and Time Liabilities (NDTL). NDTL is based on current deposits, saving deposits, term deposits, and other liabilities. This is also adjusted for the deposits from other banks. The formula for NDTL becomes:
NDTL = Demand liabilities + time liabilities + other demand and time liabilities – deposits with other banks
Reserve requirement calculation can be done by using Net demand and time liabilities.
Cash Reserve Ratio = Cash Reserve maintained with the Central Bank/Net demand and time liabilities.
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Examples of Reserve Requirements
Below are the given examples of reserve requirements to understand its calculation in a better manner.
Suppose that a bank named ABL in the United States is required by the Federal Reserve to maintain a 9.2% cash reserve. The Bank declares its net demand and time liabilities at $100 million. What is the amount of reserve that the bank will put in the Federal reserve?
Since the federal reserve has a 9.2% regulation on cash reserve, it will be applicable to the net demand and time liabilities of the bank ABL. The bank will maintain a 9.2% of its NDTL $100 million in reserve.
Cash Reserve against NDTL
Thus, it will maintain $9.2 million in the Federal Reserve vaults.
A bank in Mexico, Smith and Sons Limited, has been mandated a reserve requirement of 7.5% of its net demand and time liabilities (NDTL). If it has the following liabilities (see table) on its balance sheet and an 80% can be attributed to the NDTL, do the calculation to get the amount it should be maintaining for reserve requirement?
All figures are in US dollars.
The table above can be used to deduce total liabilities that the bank has on its balance sheet. The reserve requirement is a function of the net demand and time liabilities (NDTL) and thus, the latter can be obtained as a means of percentage of the total liabilities.
Total Liabilities & Net Demand and Time Liabilities
- Thus, total liabilities = $23 mn + $30 mn + $12 mn = $65 mn.
NDTL = 80% of total liabilities which is 80% of $65 mn
Reserve requirement = 5% of NDTL.
So, the number of reserves the bank has to make with the central bank of Mexico = $3.9 mn.
- For a long time in the history of banking, reserve requirements helped Central banks to regulate the circulation of money. It is now deemed helpful in keeping interest rates (lending rates) under check. That said, Central banks do not necessarily mandate these rates but influence or impact them.
- It also guides other rates which the banks use among themselves. For instance, the LIBOR – London Interbank Offered Rate.
- It is also a measure to keep liquidity in the system under the scanner.
- It can also be used as a tool for fighting inflation.
- Cash reserve ratio does not account for short-term funds and other marketable securities that are also considered highly liquid. Hence, it does not present a true picture of a bank’s liquidity.
- An ill-managed reserve can cause a slowdown in the economy and/or haphazard measures by financial institutions.
- Most economists in the modern era disagree with the notion of reserve requirement as controlling money circulation. They opine that with growing functionalities in the banking space reserve requirements have a lesser role to play in regulating money circulation.
- A continuous increase or decrease in reserve requirements may cause the spirit of investors to die down. reserve requirement sometimes becomes critical in investor circles.
- These requirements are changed only when needed stringently because they can be expensive to implement.
- If the reserve requirement from the Central banks is high, the member banks make fewer profits because they have a higher amount in the custody of Central banks. Vice versa, the profits are high if the reserve requirement is less.
- Banks borrow funds from the Federal Reserve as well as from each other. The funds that are borrowed and lent among the banks are known as Federal funds. And the interest rate that is charged is called the Fed funds rate.
- Any financial institution that holds amounts that are in excess of the required reserves is said to have excess reserves.
Reserve requirements may not always serve its purpose. As could be seen during the financial crisis of 2008-09, the lower interest rates and lesser the requirements could not manifest into expansionary tactics as intended. It was because of general distrust which could not be compensated through reserve requirements.
Countries like the United States, India, and Japan are mandated by their Central banks – the Federal Reserve of the United States, Reserve Bank of India and Bank of Japan respectively for reserve requirements. For a liability of more than $124.2 million, the US Federal Reserve System requires banks to put aside 10% which is effective from Jan 17, 2019. The lower limit in the United States is $2 million below which financial institutions need not abide by any reserve requirement
In the past 2 decades, the Reserve Bank of India has averaged 5.41% on the account of the Cash reserve requirement. There are countries where there is no requirement to keep cash reserves. For example, Hong Kong, United Kingdom, and Australia are free from such requirement.
This has been a guide to Reserve Requirement and its definition. Here we discuss components of the reserve requirement and examples with calculation. You can learn more about accounting from the following articles –