Reserve requirement

The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum amount of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and stored physically in the bank vault (vault cash), plus the amount of the commercial bank's balance in that bank's account with the central bank.

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The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with.[1] Western central banks rarely increase the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they generally prefer to use open market operations (buying and selling government-issued bonds) to implement their monetary policy. The People's Bank of China uses changes in reserve requirements as an inflation-fighting tool, and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010.

An institution that holds reserves in excess of the required amount is said to hold excess reserves.

Effects on money supply

Conventional view

The theory that a reserve requirement can be used as a tool of monetary policy is frequently found in economics textbooks. Under the theory, the higher the reserve requirement is set, the less funds banks will have available to lend out, leading to lower money creation and perhaps to higher purchasing power of the money previously in use. Under this view, the effect is multiplied, because money obtained as loan proceeds can be re-deposited, and a portion of those deposits may again be lent out, and so on. Under this theory, the effect on the money supply is governed by the following formulas:

: definitional relationship between monetary base MB (bank reserves plus currency held by the non-bank public) and the narrowly defined money supply, ,
: derived formula for the money multiplier m, the factor by which lending and re-lending leads to be a multiple of the monetary base:

where notationally,

the currency ratio: the ratio of the public's holdings of currency (undeposited cash) to the public's holdings of demand deposits; and
the total reserve ratio (the ratio of legally required plus non-required reserve holdings of banks to demand deposit liabilities of banks).

However, in the United States (and other countries except Brazil, China, India, Russia), the reserve requirements are generally not frequently altered to implement monetary policy because of the short-term disruptive effect on financial markets.

Endogenous money view

Most economists dispute the conventional theory of the reserve requirement.[2] Criticisms of the conventional theory are usually associated with theories of endogenous money.

Jaromir Benes and Michael Kumhof of the IMF Research Department report that the "deposit multiplier" of the undergraduate economics textbook, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through bank lending, turns the actual operation of the monetary transmission mechanism on its head. Benes and Kumhof assert that in most cases where banks ask for replenishment of depleted reserves, the central bank obliges.[3] Under this view, reserves therefore impose no constraints, as the deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth. Under this theory, private banks almost fully control the money creation process.[3]

Required reserves

United States

In the United States, a reserve requirement[4] (or liquidity ratio) is a minimum value, set by the Board of Governors of the Federal Reserve System, of the ratio of required reserves to a category of deposit liabilities (called the "Net Transaction Accounts" or "NTAs") owed by depository institutions to their customers (e.g., owed by commercial banks including U.S. branches of a foreign bank, savings and loan association, savings bank, credit union). The deposit liability categories currently subject to reserve requirements are mainly checking accounts. There is no reserve requirement on savings accounts and time deposit accounts owned by individuals.[5] The total amount of all NTAs held by customers with U.S. depository institutions, plus the U.S. paper currency and coin currency held by the nonbank public, is called M1.

As of March 2020, the minimum reserve requirement for all deposit institutions was abolished, or more technically, fixed to zero percent of eligible deposits. The Board previously mandated a zero reserve requirement for banks with eligible deposits up to $16 million, 3% for banks up to $122.3 million, and 10% thereafter. The removal of reserve requirements followed the Federal Reserve's shift to an "ample-reserves" system, in which the Federal Reserve Banks pay member banks interest on reserves that they keep in excess of the required amount.[6][7]

The International Banking Act of 1978 required branches of foreign banks operating in the United States to follow the same required reserve ratio standards.[8][9]

Countries and districts without reserve requirements

Canada, the UK, New Zealand, Australia, Sweden and Hong Kong[10] have no reserve requirements.

This does not mean that banks can—even in theory—create money without limit. On the contrary, banks are constrained by capital requirements, which are arguably more important than reserve requirements even in countries that have reserve requirements.

It also does not mean that a commercial bank's overnight reserves can become negative, in these countries. The central bank will always step in to lend the necessary reserves if necessary so that this does not happen; this is sometimes described as "defending the payment system". Historically a central bank might once have run out of reserves to lend and so have had to suspend redemptions, but this can no longer happen to modern central banks because of the end of the gold standard worldwide, which means that all nations use a fiat currency.

A zero reserve requirement cannot be explained by a theory that holds that monetary policy works by varying the quantity of money using the reserve requirement.

Even in the United States, which retained formal reserve requirements until 2020, the notion of controlling the money supply by targeting the quantity of base money fell out of favor many years ago, and now the pragmatic explanation of monetary policy refers to targeting the interest rate to control the broad money supply. (See also Regulation D (FRB).)

United Kingdom

In the UK the term clearing banks is sometimes used, meaning banks that have direct access to the clearing system. However, for the purposes of clarity, the term commercial banks will be used for the remainder of this section.

The Bank of England, which is the central bank for the entire United Kingdom, previously held to a voluntary reserve ratio system, with no minimum reserve requirement set. In theory this meant that commercial banks could retain zero reserves. The average cash reserve ratio across the entire United Kingdom banking system, though, was higher during that period, at about 0.15% as of 1999.[11]

From 1971 to 1980, the commercial banks all agreed to a reserve ratio of 1.5%. In 1981 this requirement was abolished.[11]

From 1981 to 2009, each commercial bank set out its own monthly voluntary reserve target in a contract with the Bank of England. Both shortfalls and excesses of reserves relative to the commercial bank's own target over an averaging period of one day[11] would result in a charge, incentivising the commercial bank to stay near its target, a system known as reserves averaging.

Upon the parallel introduction of quantitative easing and interest on excess reserves in 2009, banks were no longer required to set out a target, and so were no longer penalised for holding excess reserves; indeed, they were proportionally compensated for holding all their reserves at the Bank Rate (the Bank of England now uses the same interest rate for its bank rate, its deposit rate and its interest rate target).[12] In the absence of an agreed target, the concept of excess reserves does not really apply to the Bank of England any longer, so it is technically incorrect to call its new policy "interest on excess reserves".

Canada

Canada abolished its reserve requirement in 1992.[11]:347

Other countries and districts

Other countries have required reserve ratios (or RRRs) that are statutorily enforced:[13]

Country or districtRequired reserve (in %)Note
AustraliaNoneStatutory reserve deposits abolished in 1988, replaced with 1% non-callable deposits[14]
New ZealandNone1985[15]
SwedenNoneEffective 1 April 1994[16]
Eurozone1.00Effective 18 January 2012.[17] Down from 2% between January 1999 and January 2012.
Czech Republic2.00Since 7 October 2009
Hungary2.00Since November 2008
South Africa2.50
Switzerland2.50
Latvia3.00Just after the Parex Bank bailout (24.12.2008), Latvian Central Bank
decreased the RRR from 7% (?) down to 3%[18]
Poland0.50As of 30 April 2020[19]
Romania8.00As of 24 May 2015 for lei. 10% for foreign currency as of 24 October 2016.[20]
Russia4.00Effective 1 April 2011, up from 2.5% in January 2011.[21]
Chile4.50
India3.0027 March 2020, as per RBI.[22]
Bangladesh6.00Raised from 5.50, effective from 15 December 2010
Lithuania6.00
Nigeria27.50Raised from 22.50, effective from January 2020[23]
Pakistan5.00Since 1 November 2008
Taiwan7.00[24]
Turkey8.50Since 19 February 2013
Jordan8.00
Zambia8.00
Burundi8.50
Ghana9.00
Iceland2.00[25]
Israel6.00the reserve requirement is reflected in the bank of israel law.
Mexico10.50
Sri Lanka8.00With effect from 29 April 2011. 8% of total rupee deposit liabilities.
Bulgaria10.00Banks shall maintain minimum required reserves to the amount of 10% of the deposit base (effective from 1 December 2008) with two exceptions (effective from 1 January 2009): 1. on funds attracted by banks from abroad: 5%; 2. on funds attracted from state and local government budgets: 0%.[26]
Croatia9.00Down from 12%, from 10 April 2020[27]
Costa Rica15.00
Malawi15.00
Nepal6.00From 20 July 2014 (for commercial banks)[28]
Hong KongNone[10]
Brazil21.00Term deposits have a 33% RRR and savings accounts a 20% ratio.[29]
China17.00China cut bank reserves again to counter slowdown as of 29 February 2016.[30]
Tajikistan20.00
Suriname25.00Down from 27%, effective 1 January 2007[31]
Lebanon30.00[32]

See also

References
  1. "Monetary Policy Aims - Bank of Russia". archive.org. 7 July 2001.
  2. Michael, McLeay. "Money creation in the modern economy" (PDF). Bank of England.
  3. Benes, Jaromir; Kumhof, Michael (2012). "The Chicago Plan Revisited" (PDF). International Monetary Fund.
  4. See generally Regulation D, at 12 C.F.R. sec. 204.4 and sec. 204.5
  5. "eCFR – Code of Federal Regulations". www.ecfr.gov.
  6. "The Fed - Reserve Requirements". federalreserve.gov.
  7. The Fed Fires ‘The Big One’
  8. Ahorny, Joseph; Saunders, Anthony; Swary, Itzhak (1985). "The Effects of the International Banking Act on Domestic Bank Profitability and Risk". Journal of Money, Credit, and Banking. JSTOR. 17: 493–506. JSTOR 1992444.
  9. "International Banking Act of 1978". Banking Law 101.
  10. "Central banks' exit strategies from quantitative easing". Hong Kong Monetary Authority. Retrieved 13 August 2009.
  11. Jagdish Handa (2008). Monetary Economics (2nd ed.). Routledge.
  12. "Sterling Operations - Implementation of Monetary Policy". Bank of England. Retrieved 26 August 2013.
  13. Lecture 8, Slide 4: "Central Banking and the Money Supply" from the presentation Monetary Macroeconomics by Dr. Pinar Yesin, University of Zurich, based on 2003 survey of CBC participants at the Study Center Gerzensee
  14. "Inquiry into the Australian Banking Industry", Reserve Bank of Australia, January 1991
  15. "Abolition of compulsory ratio requirements". Reserve Bank Bulletin. Vol. 48 no. 4. Reserve Bank of New Zealand. April 1985.
  16. Lotsberg, Kari (1994). "Riksbanken reducerar kassakraven för bankerna till noll" (PDF). Penning- & valutapolitik (in Swedish). No. 1994:2. pp. 45–47. Archived from the original (PDF) on 8 December 2015. Retrieved 1 December 2015.
  17. Bank, European Central. "How to calculate the minimum reserve requirements". European Central Bank.
  18. "Minimum Reserve Ratio". Bank of Latvia. Retrieved 29 December 2010.
  19. "Narodowy Bank Polski - Internet Information Service". nbp.pl.
  20. "Banca Naţională a României - Reserve requirements". www.bnr.ro.
  21. Central bank of Russia Required reserve ratio on credit institutions' liabilities to non-resident has been raised to 4.0%
  22. "RBI cuts repo rate by 75 bps to 4.40% to mitigate Covid-19 impact". The Economic Times. 27 March 2020.
  23. Bamidele Samuel Adesoji (24 January 2020). "CBN raises CRR to 27.5%, holds MPR, other parameters constant". Nairametrics.com.
  24. Liquidity ratio and liquid reserves of deposit money banks. Data released by Taiwan's central bank in October 2010.
  25. "Iceland Reserve Requirement Ratio | Economic Indicators". www.ceicdata.com. Retrieved 9 January 2018.
  26. "Ordinance No. 21 of the BNB on the Minimum Required Reserves Maintained with the Bulgarian National Bank by Banks" (PDF). Bulgarian National Bank.
  27. Decision on Reserve Requirements, Croatian National Bank (in Croatian)
  28. "Nepal Rastra Bank". www.nrb.org.np.
  29. "Circular 3.632" (PDF). bcb.gov.br.
  30. CNBC (29 February 2016). "China central bank cuts reserve requirement ratio". cnbc.com.
  31. "Reserve base en Kasreserve". Centrale Bank van Suriname. Retrieved 21 December 2009.
  32. "Lebanon 'immune' to financial crisis". 5 December 2008 – via news.bbc.co.uk.
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