What is the Reserve Requirement?
Reserve Requirement is the liquid cash amount in proportion of its total deposit required to be kept either in the bank or deposited in the central bank. Therefore, the bank cannot access it for any business or economic activity. The minimum reserve requirement also ensures that banks are better prepared for unexpected surplus deposits or withdrawals.
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It is mandated by central banks worldwide for their member banks to regulate the safety cash held by the banks. This cash reserve serves many different purposes in different economies. For example, the Central bank of the United States is the Federal Bank, which holds authority over this requirement in the United States. The People’s Bank of China functions similarly to Chinese banks.
Table of contents
Reserve Requirement Explained
Reserve requirement is a regulation set by the central bank of a country for commercial banks to maintain a certain percentage of liquid assets to ensure they do not create more spaces for credit, and maintain a certain percentage to meet any unusually high deposits or withdrawals.
However, reserve requirement ratio may not always serve its purpose. As could be seen during the financial crisisThe Financial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more of 2008-09, the lower interest rates and lesser requirements could not manifest into expansionary tactics as intended. Instead, it was because of general distrust that could not be compensated through these 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 such requirements.
In the past two decades, the Reserve Bank of India has averaged 5.41% on the Cash reserve requirement. There are countries where there is no requirement to keep cash reserves. For example, Hong Kong, the United Kingdom
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Formula
The formula to calculate and find the minimum reserve requirement is as explained below:
Reserve Ratio = Reserve Maintained With The Central Bank / Bank Deposits x 100
How To Calculate?
Reserve requirement ratio 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 deposits from other banks. The formula for NDTL becomes:
NDTL = demand liabilities + time liabilities + other demand and time liabilities – deposits with other banks
The calculation can be done by using Net demand and time liabilities.
Cash Reserve RatioCash Reserve RatioCash Reserve Ratio refers to the share of a Bank’s total deposits that need to be maintained with the respective Country’s Central Bank to control financial supply in the economy. read more = Cash Reserve maintained with the Central Bank/Net demand and time liabilities.
Examples
Let us understand the reserve requirement ratio in detail with the help of a couple of examples.
Example #1
Suppose that the Federal Reserve requires a bank named ABL in the United States 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 the bank will put in the Federal reserve?
Solution:
Since the federal reserve has a 9.2% regulation on cash reserves, it will apply to the net demand and time liabilities of the bank ABL. Therefore, the bank will maintain 9.2% of its NDTL of $100 million in reserve.
Cash Reserve against NDTL
- =$100*9.2%
- =$9.2
Thus, it will maintain $9.2 million in the Federal Reserve vaults.
Example #2
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.
Solution
The table above can deduce the total liabilities 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 percentage of the total liabilities.
Total Liabilities & Net Demand and Time Liabilities
- Thus, total liabilities = $23 million + $30 million+ $12 million= $65 million.
NDTL = 80% of total liabilities which is 80% of $65 million
Reserve requirement = 5% of NDTL.
Amount Reserves
- =$3.9
So, the number of reserves the bank has to make with Mexico’s central bank = $3.9 million.
Advantages
Let us understand the advantages of maintaining a minimum reserve requirement from the perspective of commercial banks and on a larger scale for the economy through the explanation below.
- For a long time in banking history, reserve requirements helped Central banks regulate the circulation of money. It is now deemed helpful in keeping interest rates (lending rates) under check. Central banks do not necessarily mandate these rates but influence or impact them.
- It also guides other rates that the banks use among themselves. For instance, the LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more – 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.
Disadvantages
Despite the points mentioned above, a few factors act as a hindrance to the functioning of a commercial bank on a daily basis. Let us understand the disadvantages of the reserve requirement ratio through the points below.
- A continuous increase or decrease in reserve requirements may cause the spirit of investors to die down. They sometimes become critical in investor circles.
- These requirements are changed only when needed stringently because they can be expensive to implement.
Limitations
Let us understand the limitations of maintaining a minimum reserve requirement through the points below.
- The cash reserve ratio does not account for short-term funds and other marketable securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more 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 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, such requirements have a lesser role in regulating money circulation.
Important Points
Since we have understood the concept of reserve requirement ratio in detail, it is also important to know a few things that play a major role in the regulation of this ratio. Let us quickly recollect those points through the discussion below.
- 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 this requirement is less.
- Banks borrow funds from the Federal Reserve as well as from each other. The funds 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 over the required reserves is said to have excess reserves.
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