Bank reserves are the required minimum cash for all lending and deposit-taking financial institutions in a specific jurisdiction to have in hard cash at all times. The central bank of each country is responsible for determining the amount of minimum reserve.
How does the reserve requirement work?
The reserve ratio is determined by the respective country’s central banks. The main criterion for determining the reserve ratio varies from nation to nation. However, it is always based on the amount of cash deposited into each financial institution. Larger banks are required to maintain a higher reserve ratio because of the greater risk of collapse they pose.
A bank’s size and overall economic importance are used to classify it into one of several categories. This means that the reserve ratios for various banks will be different depending on which category the bank belongs to.
Let’s say a bank has $10 million cash on hand and it is required to keep a $1 million cash reserve on hand at all times. This enables it to issue loans of $9 million. As a result, the overall economy has more money as the loans help businesses expand and individuals to buy homes, cars, etc. The $1 million will ensure that the bank can still support withdrawals from its account holders.
In the absence of a reserve, this wouldn’t be possible as the bank would probably lend out all the money. That would be very frustrating to many account holders because they would not access their money when they need it.
In addition, and perhaps the most impactful aspect of reserve ratios, is their use in promoting monetary policies geared towards achieving certain economic goals. The most common way to do this is by regulating the amount of money in circulation and, by extension, triggering interest rate changes. Therefore, changes to the reserve ratio can give us a good understanding of an economy’s monetary policy at a particular time.
Lowering this ratio enables banks to be better equipped to lend cash. It leaves them with comparatively more cash to lend, and they, in turn, lower their interest rates to incentivize borrowers. The converse is true for higher ratios. It forces banks to keep significantly higher amounts of money, leaving them with less to lend. As a result, they have to raise interest rates.
The impact of interest rates vs reserve balances
When interest rates are adjusted, they either encourage or discourage borrowing. Consequently, they influence the amount of local currency in circulation and therefore affect the value of such currencies.
Raising the reserve ratio goes hand-in-hand with higher interest rates. Banks do not raise interest rates out of their own volition but out of the need to cover their operating costs and profit margins. With lower reserve requirements, banks have more money freed up, which enables them to lend more, which in turn necessitates lowering interest rates. Ultimately, reduced interest rates encourage borrowing and spending, which stimulates economic productivity and growth.
In a similar vein, central banks might raise reserve requirements for banks in order to keep the economy from overheating as a result of inflation. When the reserve ratio is raised, less money becomes available for lending, leading to a rise in interest rates. High-interest rates discourage borrowing and lead to reduced consumer spending, which slows down economic activity.
Changes to the reserve requirement are a time-consuming and expensive process for financial institutions. Because of this, when monetary policy changes, the reserve requirement is often left unchanged. Although less controversial than reserve requirements, open market operations (OMOs) are nevertheless powerful monetary policy instruments that are often chosen as an alternative.
OMO is a term used to describe central banks’ T-bill market actions. Central banks can purchase and sell government-issued bonds on these markets, which are usually open to international investors.
Central banks can regulate the amount of money in an economy by buying and selling bonds. When central banks want to stimulate the economy, they can acquire government bonds on the open market. Whenever the government buys bonds, it releases funds that can be used by financial institutions to expand their lending capabilities. Banks decrease interest rates to promote even more borrowing as money becomes more plentiful in the economy. This leads to more economic expansion.
The other way is for the central banks to sell bonds. When they do this, because of the high premium placed on governments’ ability to repay their loans, banks usually rush to buy these bonds. By doing this, the central bank gets its contractionary policy working by mopping up significant sums of money from the economy. This results in less money being available to lend to institutions and individuals. In addition to this, banks usually raise their interest rates as a control measure to safeguard their operating margins.
This policy prevents the economy from overheating by causing a slowdown in consumption and investment.
The downside to reserve requirements
Typically, central banks avoid making frequent reserve requirement adjustments because doing so significantly affects banks’ ability to lend money. Raising the ratios can especially have a devastating impact on smaller financial institutions because it leaves them with very little money to lend, thus technically locking them out of business.
Minimum reserve requirements are integral to maintaining proper discipline and integrity in the financial sector. They are intended to maintain the stability of money market interest rates as well as to maintain control over liquidity. Ultimately, not only do banks benefit from such streamlining measures, but the economy also gains, and investors’ deposits are safeguarded.