What It Measures
In the United Kingdom and in certain European countries there is no compulsory ratio, although banks will have their own internal measures and targets to be able to repay customer deposits as they forecast they will be required. In the United States the policy is more prescriptive, and specified percentages of deposits—specified by the Federal Reserve Board—must be kept by banks in a noninterest-bearing account at one of the 12 Federal Reserve Banks located throughout the country.
Why It Is Important
To provide stability. In view of the volume and unpredictability of transactions that clear through their accounts every day, banks and financial depositories must maintain a cushion of funds to protect themselves against debits that could leave their accounts overdrawn at the end of the day, and thus subject to penalty.
As a result of the creation of reserve ratios, periods of financial stress are no longer characterized by runs on banks by depositors.
How It Works in Practice
In Europe, the reserve requirement of an institution is calculated by multiplying the reserve ratio for each category of items in the reserve base, set by the European Central Bank, with the amount of those items in the institution’s balance sheets. These figures vary according to the institution.
The required reserve ratio in the United States is set by federal law, and depends on the amount of checkable deposits a bank holds. The first $44.3 million of deposits are subject to a 3% reserve requirement. Deposits in excess of $44.3 million are subject to a 10% reserve requirement. These breakpoints are reviewed annually in accordance with money supply growth. No reserves are required against certificates of deposit or savings accounts.
The reserve ratio requirement limits a bank’s lending to a certain fraction of its demand deposits. The current rule allows a bank to issue loans to an amount equal to 90% of such deposits, holding 10% in reserve. The reserves can be held in any combination of vault cash and deposit at a Federal Reserve Bank.
A bank facing a reserve deficiency has several options. It can try to borrow reserves for one or more days from another bank, sell marketable assets such as government securities, or bid for funds in the money market, such as large certificates of deposit (CDs) or eurodollars. As a last resort, it can pledge collateral and borrow at the Federal Reserve’s discount window.
In order to meet deposit withdrawal contingencies, many banks maintain a margin of excess reserves above the required reserve ratio, since the required reserves are really not available to meet withdrawal liquidity needs. Excess reserves are higher than those needed to meet reserve and clearing requirements, and provide extra protection against overdrafts and deficiencies in required reserves.
Tricks of the Trade
Because reserves earn no interest, they have an adverse effect on bank earnings.
In practice, the required reserve ratio has been adjusted only infrequently by the US Federal Reserve Board.
US depository institutions hold required reserves in one of two forms: vault cash on hand at the bank or—more significant for monetary policy—required reserve balances in accounts with the Reserve Bank for their respective Federal Reserve District.