What is Required Reserve?

A required reserve is an amount of cash that banks must keep with themselves, which is certain percentage of the deposits made by their customers. Required reserve is a percentage of the bank's deposits that the respective bank must have on each overnight. The percentage rate is set and determined by the nation’s central bank. It is important to have such funds accumulated to meet its uncertain obligations, sudden liabilities and withdrawals. Required reserve is also known as reserve ratio. Reserve ratio is an important tool to control the money supply.

Why do we need to have the Required Reserve?

Required reserve are the portion of funds allocated from the deposits of the customers. Having such reserves is a necessity as per the central bank’s regulation. In the US, for member banks, the Federal Reserve Board (FRB) of Governors manages and controls the reserve requirement. Required reserve is the minimum amount of reserves that banks must keep aside for future uncertain events and it must comply with the central bank’s prescribed percentage to be necessarily maintained.

In other words, reserve requirements should not be less than a stipulated percentage of the number of deposit liabilities that a bank is liable to pay to its customers.

In case, the bank doesn't keep aside sufficient liquid cash on hand to meet its liability, it can lend from other banks. It can also lend from the Federal Reserve. The money that banks borrow or lend to each other to satisfy the reserve needs is known as federal funds.

Federal funds commonly known as fed funds are excess reserves that any bank including financial institutions must deposit at regional Federal Reserve banks. The interest they require to pay each other for using federal funds is the federal funds rate. The necessity of the fund in the situation of any urgency is to be managed by taking and providing funds to each other, these loans are given at lower rates to meet their urgent needs and this lower interest rate is known as federal fund rate or overnight rate.

The requirement of reserve applies to commercial banks, savings banks, savings and loan associations, and credit unions.

Features of Required Reserve

·  Reserve the requirement is maintained at a pre-determined rate on the public deposits at a percentage rate

·   It is required to be maintained each night to recover from sudden uncertainty.

·  The sum must be deposited in the federal bank's vault all the time for future needs.

·  Commercial Banks must adhere to the central bank's regulation to save from a bank run and uses this method to control the money supply in the market and to maintain liquidity.

·  Reserve a requirement is a tool utilized by the banks to extend or shorten the cash supply within the economy and impact interest rates.

·  Interest rates on these borrowing work in controlling inflation, growth, and opportunities.

The History of Reserve Requirements

The practice to save a certain portion of amounts of total public deposits first started in the 19th century by commercial banks. Each bank had its currency notes that were only medium in place in the geographical area of operation by the banks. For currency exchange-related issues such as charging higher interest rates on the borrowings and lack of sufficient knowledge of other regions bank funds. To solve this issue, New York bank and New Jersey decided mutually for redemption at their branches, for this both the banks issuing bank and redeeming bank need to deposit and maintain a deposit of gold or its equivalent. Later on, the National Bank Act of 1863 came into light and imposed a 25 percent rate of the reserve for banks under its member banks.

These reserve requirements and tax implications on state banknotes in 1865 confirm that national bank notes replace other currencies as an exchange medium. For this federal reserves are created and in 1913 it expands its branches as constituent banks. They all work as lenders of the last resort and eliminating the risks and costs to maintain such reserves. It also mitigated the issue of paying higher interest rates on the borrowings.

In the times of COVID-19 pandemic, effective March 26, 2020, the Federal Reserve reduces the reserve requirement ratio to zero across all depositories. The purpose of this reduction was taken to deal with the pandemic and to jump-start the economy by indicating banks to use additional liquidity for borrowing to individuals and business houses.

Reserve vs. Capital Requirements

Some countries do not require maintaining such reserve needs such as the United Kingdom, Canada, Sweden, Australia, and Hong Kong. Wealth can not be generated or created without applying limits. But some countries among these comply to maintain capital needs. For this purpose, these countries arrange and maintain a certain percentage in their banks as the capital requirement to deal with uncertain events. It is the amount that a bank and financial institution must set aside as capital requirements. This is the amount of capital a bank or financial institution must possess as decided by its “financial regulator”.

What is Excess reserve?

Excess reserves are the capital reserves held by the banks or financial institutions over and above the required reserves to be maintained over the amount required by the regulator, towards its liabilities, and for internal controls.

For the commercial banks, Excess reserve is the amount over standard reserve as decided by the central bank. These excess reserve funds are available in the form of cash and cash equivalents by the banks above the central bank's requirements.

Do we need Excess reserve?

Excess reserves are a cautious accumulated fund that banks maintain and carried forward. These excess reserve funds are accumulated as an extra safety to meet immediate payments of loans and cash withdrawals by its customers. These excess reserve funds make the financial firm more robust and economically viable in times of economic crisis. Excess reserves also help in gaining credibility in the financial market.

In the United States, for banks reserves are those holdings that banks have in the form of cash and credit balance in the federal bank having such excess funds for a long period may inculcate an opportunity to earn income by way of interest through investing in higher risk-adjusted investments.

The interest rate is the charge that the borrowing banks have to pay to the acquiring bank for the use of the fund in times of lack of funds to meet its obligations. It is directly dependent on the period for which the borrowed funds are taken.

Impact on Monetary Policy

In the United States, Federal Reserve, commonly known as Fed, use different methods to control the money flow in the economy and control the liquidity. It also acts as an instrument to deal with inflation, growth, and employment. To control the flow of money Federal Reserve changes its policy. If in the economy inflation is keep on rising and prices of a commodity rise, in such situations, the fed may reduce its interest rates through change in policy.

It is the duty of the Federal Reserve to lay down such macro- economic policies. This involves managing the money supply and controlling the interest rates according to the need of the economy to gain macroeconomic objectives like inflation, growth, consumption, and liquidity.

Classification of Monetary Policy

It can be divided into:

Expansionary: In the expansionary monetary policy, the central government decides to lower the interest rates to ease the funding for individuals and businesses.

Contractionary: In contractionary monetary policy, the central government tightens the money flow by increasing the interest rates.

Further instruments or tools used by the Federal Reserve to regulate the economy include open market operations, bank reserve requirements, direct lending to banks, non-ordinary emergency lending programs, and controlling market expectations, by taking into consideration the credibility of banks.

Analysis of Required Reserve and Excess Reserve

The demand for having excess reserves is kept on rising and to adhere with the bank's desire to supply money to each other for managing their liquidity or financial crisis. For this purpose, the Federal Reserve has implemented several credit ease policies such as giving loans to financial institutions and financial firms to render them maintaining financial stability, and to adjust with the credit markets. One of the expansionist liquidities programs that have been implemented by the Fed’s is the purchase of government office obligations and mortgage-backed securities. To address the issue of expansion and growth in the economy the central bank has changed its interest rates for meeting the obligations. For this central bank’s purchases government-backed securities from the banks and vice-versa.

Excess reserves are excess funds that banks keep beyond regulation. As federal reserve pays interest rates on these excesses, it is a source of income for banks.

Context and Applications

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for

  • MBA
  • BBA
  • Bachelor of Commerce
  • B. Com (Hons)

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