How Reserve Requirements Work ?
RESERVE Requirements are one of the most important features of modern central banking. We hear about reserve requirements almost every day in the media. When central banks like the Fed change these requirements, it is said to have a huge impact on the markets. Liquidity worth billions of dollars is said to be either released or sucked out from the system. But do we really know how reserve requirements work?
In this article, we will understand what reserve requirements really are and how they are implemented.
What are Reserve Requirements ?
The modern banking system is a fractional reserve banking system. This means that when the bank receives deposits, it is only required to maintain a certain percentage of these deposits in the form of cash on hand. The rest can be utilized to make loans.
Therefore, if the banks keep too much cash on hand, they are simply losing out on additional interest that could be earned by lending out that money. On the other hand, if they lend out too much and keep too little as reserves, there might be a possibility of a “bank run” and immediate insolvency of the bank. Earlier the decision regarding how much to hold in reserves was taken by the banks themselves. However, many of them were not good at estimating the reserve requirements and ended up landing in trouble.
In order to mitigate this problem, the central banks have started prescribing the required reserve requirements. It is now the legal responsibility of commercial banks to maintain the reserve requirements as prescribed by their central banks.
Another important point that needs to be noted is that reserve requirements are usually applicable only to demand deposits i.e. money in savings accounts, negotiable order of withdrawal (NOW) accounts, current accounts etc. In most countries around the world, reserve requirements are not applicable to time deposits i.e. money that is loaned out to the banks for a fixed period of time.
Example:
For instance, if a bank receives $500 as demand deposits and $200 as time deposits during the given period and the reserve requirement ratio is 10%. The reserve computation will be as follows:
Reserve Requirement on Demand Deposits = 10% of $500 = $50
Reserve Requirement on Time Deposits = 0% of $200 = $0
Total Reserve Requirements = $50
Reserves as Tools of Monetary Policy
Reserve requirements are remnants of an era gone by. The primary reason why reserves were required to be held was to prevent bank runs from happening. However, in the modern banking system, the Fed provides unlimited liquidity to its member banks in the event of a bank run. Thus, the banks have no real need to hold reserves since their solvency is guaranteed by the Fed.
In the modern times, reserve requirements have become more of a tool of monetary policy. This means that the central bank uses it to increase and decrease the amount of money supply in the system and therefore influence inflation. When central banks increase reserve requirements, the speed of credit creation is slowed down and liquidity is sucked out of the system. When they lower the reserve requirements, the opposite happens.
The purpose for which reserve requirements were held has undergone a drastic change. It is no longer a safety net against bank runs
SOURCE:WWW.MANAGEMENTSTUDYGUIDE.COM