Reserve requirement

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:

${\displaystyle M_{1}=MB*m\,}$ : definitional relationship between monetary base MB (bank reserves plus currency held by the non-bank public) and the narrowly defined money supply, ${\displaystyle M_{1}}$,

${\displaystyle m={\frac {(1+c)}{(c+R)}}={\frac {1+{\frac {C}{D}}}{{\frac {C}{D}}+R}}}$ : derived formula for the money multiplier m, the factor by which lending and re-lending leads ${\displaystyle M_{1}}$ to be a multiple of the monetary base:

where notationally,

${\displaystyle c=}$ the currency ratio: the ratio of the public's holdings of currency (undeposited cash) to the public's holdings of demand deposits; and

${\displaystyle R=}$ 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.

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.[4]

In the United States, a reserve requirement[5] (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.[6] 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.[7][8]

The International Banking Act of 1978 required branches of foreign banks operating in the United States to follow the same required reserve ratio standards.[9][10]

Canada, the UK, New Zealand, Australia, Sweden and Hong Kong[11] 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).)

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.[12]

From 1971 to 1980, the commercial banks all agreed to a reserve ratio of 1.5%. In 1981 this requirement was abolished.[12]

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[12] 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).[13] 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 abolished its reserve requirement in 1992.[12]

Other countries have required reserve ratios (or RRRs) that are statutorily enforced:[14]