interest

Bank reserves refer to the amount of funds a financial institution must have on-hand at any given time. These reserves are a percentage of its total deposits set aside to fulfill withdrawal requests, and comply with regulations and can also provide a layer of trust for account holders.

Bank reserves act as assurance to depositors that there is always a certain amount of cash on deposit, so the scenario mentioned above doesn’t happen. No one wants to ever withdraw some cash and be left empty-handed. As a consumer with a bank account, it can be important to understand the role bank reserves play in the financial system and the economy.

What Are Bank Reserves?

Bank reserves are the minimum deposits held by a financial institution. The central bank of each country decides what these minimum amounts must be. For example, in the United States, the Federal Reserve determines all bank reserve requirements for U.S. financial institutions. In India, as you might guess, the Reserve Bank of India determines the bank reserves for that country’s financial institutions.

The bank reserve requirements are in place to ensure the financial institution has enough cash to meet financial obligations such as consumer withdrawals. It also ensures that financial institutions can weather historical market volatility (that is, economic ups and downs).

Bank reserve requirements are typically a percentage of the total bank deposit amounts determined by the Federal Reserve Board of Governors. Financial institutions can hold their cash reserves in a vault on their property, with the regional Federal Reserve Bank, or a combination of both. This way, the financial insulation will have enough accessible funds to support their operational needs while letting the remaining reserves earn interest at a Federal Reserve Bank.

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How Do Bank Reserves Work?

Bank reserves work to ensure that a certain amount of cash, or percentage of overall deposits, is kept in a financial institution’s vault.

Suppose you need to withdraw $5,000 to purchase a new car. You understand savings account withdrawal limits at your bank and the amount you need is within the guidelines, so you head to your local branch. When you arrive, you’re told they don’t have enough money in their vault to meet your request.

This is what life could be like without bank reserves. The thought of not being able to withdraw your own money might be upsetting, worrisome, and deeply inconvenient. To prevent this kind of situation is exactly why banks must have a certain percentage of cash on hand.

In addition to ensuring consumers have access to their money, bank reserves may also aid in keeping the economy functioning efficiently. For example, suppose a bank has $10 million in deposits, and the Federal Reserve requires 3% liquidity. In this case, the bank will need to keep $300,000 in its vault, but it can lend the remaining $9.7 million to other consumers via loans or mortgages. Consumers can use this money to buy homes and cars or even send their children to college. The interest on those loans is a way that the bank earns money and stays in business.

Bank reserves are vital in helping the economy control money supply, interest rates, and the implementation of what is known as monetary policy. When the reserve requirements change, it says a lot about the economy’s direction. For example, when reserve requirements are low, banks have more opportunity to lend since more capital is at their disposal. Thus, when the money supply is plentiful, interest rates decrease. Conversely, when reserve requirements are high, less money circulates, and interest rates rise.

During inflationary periods, the Federal Reserve may increase reserved requirements to ensure the economy doesn’t combust. Essentially, by decreasing the money supply and increasing interest rates, it can slow down the rate of investments.

Recommended: Understanding Fractional Reserve Banking

Types of Bank Reserves

There are two types of bank reserves: required reserves and excess reserves. The required reserves are the percentage of deposits the institution must have in cash holdings and deposit balances to abide by the regulations of the Federal Reserve. Excess reserves are the amount over the required reserve amount that the institution holds.

Excess reserves can provide a larger safety net for the financial institution and enhance liquidity. It can also contribute to a higher credit rating for institutions. On the other hand, excess reserves can also result in losing the opportunity to invest the funds to yield higher returns. In other words, since the extra money is sitting in cash, it will not generate the same returns it might yield by lending or investing in the market.

Recommended: What Is Quantitative Easing?

History of Bank Reserves

Reserve requirements first came about in 1863 during the passing of the National Bank Act. This act intended to create a national banking system and currency so money could flow easily throughout the country. At this time, banks had to hold at least 25% reserves of both loans and deposits. Bank reserves were necessary to ensure financial institutions had liquidity and money could continue circulating freely throughout the nation.

But despite the efforts to establish a robust banking system, banking troubles continued. After the panic of 1907, the government intervened, and in 1913, Congress passed the Federal Reserve Act to address banking turmoil. The central bank was created to balance competing interests and foster a healthy banking system.

Initially, the Federal Reserve acted as a last resort and a liquidity grantor when the banks faced trouble. During the 1920s, the Federal Reserve’s role expanded to playing a proactive role in the economy by influencing the credit conditions of the nation.

After the Great Depression, a landmark in the history of U.S. recessions and depressions, the Banking Act of 1935 was passed to reform the structure of the Federal Reserve once again. As part of this act, the Federal Open Market Committee (FOMC) was born to oversee all monetary policy.

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How the 2008 Crisis Impacted Bank Reserves

Prior to the global financial crisis of 2008, financial institutions didn’t earn interest on excess reserves held at a Federal Reserve Bank. However, after October 2008, the Federal Reserve was granted the right to pay interest to banks with excess reserves. This encourages banks to keep more of their reserves. The Board of Governors establishes the interest on reserve balances (IORB rate). As of July 2024, the IORB was 5.4%.

Then, after the recession subsided in 2009, the Federal Reserve turned its attention to reform to avoid similar economic disasters in the future.

Recommended: Federal Reserve Interest Rates, Explained

How Much Money Do Banks Need to Keep in Reserve?

Reserve requirements vary depending on the size of the financial institution. As of July 2024, reserve requirements are 0%, where they’ve been since early 2020 and the onset of the COVID-19 pandemic.

Prior to this revision, banks with between $16.9 to $127.5 million in deposits were required to have 3% in reserves, whereas banks over this amount had to have at least 10% in bank reserves.

Recommended: Investing During a Recession

What Is Liquidity Cover Ratio (LCR)?

Bank reserve requirements aside, financial institutions want to ensure they have enough liquidity to satisfy the short-term financial obligations if an economic crisis occurs. This way, they know they will be able to weather a crisis and not face complete bankruptcy. Therefore, financial institutions use the Liquidity Coverage Ratio (LCR) to prevent financial devastation resulting from a crisis.

The LCR helps financial institutions decide how much money they should have based on their assets and liabilities. To calculate the LCR, banks use the following formula:

(Liquid Assets / Total Cash Outflows) X 100 = LCR

Liquid assets can include cash and liquid assets that convert to cash within five business days. Cash flows include interbank loans, deposits, and 90-day maturity bonds.

The minimum LCR should be 100% or 1:1, though this can be hard to achieve. If the LCR is noticeably lower than this amount, the bank may have liquidity concerns and put the bank’s assets at risk.

The Takeaway

Financial institutions must have a certain amount of cash on hand, referred to as bank reserves. These assets are usually kept in a vault on the bank’s property or with a regional Federal Reserve Bank. These cash reserves ensure financial institutions can support consumer withdrawals and withstand a financial crisis.

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FAQ

Are bank reserves assets or liabilities?

Bank reserves are considered an asset since they’re an item the bank owns. Other bank assets can include loans and securities.

How are bank reserves calculated?

Bank reserve requirements are calculated as a percentage of the institution’s deposits. So, if the reserve requirement is 3% for banks with $10 million in deposits, the bank would have to hold $300,000 in its reserves.

Where do banks keep their reserves?

Financial institutions usually keep a certain amount of their cash reserves in a vault to meet operational needs. The remaining amount may be kept at Federal Reserve Banks so the balance can generate interest.

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Photo credit: iStock/Diy13

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