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Reserve requirement

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The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out). These required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank.

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 alter 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,[2] and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits and zero on time deposits and all other deposits.

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

Contents

Effects on money supply

The reserve requirement can be used as an instrument of monetary policy, because the higher the reserve requirement is set, the less funds banks will have to loan out, leading to lower money creation and perhaps ultimately to higher purchasing power of the money previously in use. The effect is multiplied, because money obtained as loan proceeds can be re-deposited; a portion of those deposits may again be loaned out, and so on. The effect on the money supply is governed by the following formulas:

M1=Mb*mm \, : definitional relationship between monetary base Mb (bank reserves plus currency held by the non-bank public) and the narrowly defined money supply, M1,
mm=(1+c)/(c+R) \, : derived formula for the money multiplier mm, the factor by which lending and re-lending leads M1 to be a multiple of the monetary base:

where notationally,

c = the currency ratio: the ratio of the public's holdings of currency (undeposited cash) to the public's holdings of demand deposits; and
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.

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.

At all times, when banks ask for reserves, the central bank obliges. Reserves therefore impose no constraint. The deposit multiplier is simply, in the words of Kydland andPrescott (1990), a myth. And because of this, private banks are almost fully in control of the money creation process. [3]

Required reserves

United States

In the United States, a reserve requirement (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 some category of deposits held at depository institutions (e.g., commercial bank including US branch of a foreign bank, savings and loan association, savings bank, credit union). The only deposit categories currently subject to reserve requirements are net transactions accounts, mainly checking accounts. The total amount of all net transaction accounts held in USA depository institutions, plus US currency held by the nonbank public, is called M1.

A depository institution can satisfy its reserve requirements by holding either vault cash or reserve deposits. An institution that is a member of the Federal Reserve System must hold its reserve deposits at a Federal Reserve Bank. Nonmember institutions can elect to hold their reserve deposits at a member institution on a pass-through basis.[4]

A depository institution's reserve requirements vary by the dollar amount of net transaction accounts held at that institution. Effective December 29, 2011, institutions with net transactions accounts:

  • Of less than $12.4 million have no minimum reserve requirement;
  • Between $12.4 million and $79.5 million must have a liquidity ratio of 3%;
  • Exceeding $79.5 million must have a liquidity ratio of 10%.[4]

The numerical amounts stated above are recalculated annually according to a statutory formula.

Effective December 27, 1990, a liquidity ratio of zero has applied to CDs, savings deposits, and time deposits, owned by entities other than households, and the Eurocurrency liabilities of depository institutions. Deposits owned by foreign corporations or governments are currently not subject to reserve requirements.[4]

When an institution fails to satisfy its reserve requirements, it can make up its deficiency with reserves borrowed either from a Federal Reserve Bank, or from an institution holding reserves in excess of reserve requirements. Such loans are typically due in 24 hours or less.

An institution's overnight reserves, averaged over some maintenance period, must equal or exceed its average required reserves, calculated over the same maintenance period. If this calculation is satisfied, there is no requirement that reserves be held at any point in time. Hence reserve requirements play only a limited role in money creation in the USA.

United Kingdom

The Bank of England holds to a voluntary reserve ratio system, with no minimum reserve requirement set. In theory this means that banks could retain zero reserves, effectively allowing an infinite amount of credit money creation. However, the average cash reserve ratio across the entire United Kingdom banking system is higher, with a 3.1% average as of 1998.

Other countries

Other countries have required reserve ratios (or RRRs) that are statutorily enforced (sourced from Lecture 8, Slide 4: Central Banking and the Money Supply, by Dr. Pinar Yesin, University of Zurich, based on 2003 survey of CBC participants at the Study Center Gerzensee[5]):

Country Required reserve (in %) Note
Australia None Statutory Reserve Deposits abolished in 1988,
replaced with 1% Non-callable Deposits[6]
Canada None
New Zealand None

1999 [3]
Sweden None
Eurozone 1.00 Effective January 18, 2012.[7] Down from 2% since Jan 1999.
Czech Republic 2.00 Since October 7, 2009
Hungary 2.00 Since November 2008
South Africa 2.50
Switzerland 2.50
Latvia 3.00 Just after the Parex Bank bailout (24.12.2008), Latvian Central Bank
decreased the RRR from 7% (?) down to 3%[8]
Poland 3.50 as of 31 dec 2010 [9]
Romania 15.00 as of 30 jan 2013 for lei. And 20% for foreign currency[10]
Russia 4.00 Effective April 1, 2011, up from 2.5% in January 2011.[11]
Chile 4.50
India 4.00 January 2013, as per RBI.[12]
Bangladesh 6.00 Raised from 5.50. Effective from 15 December 2010
Lithuania 6.00
Pakistan 5.00 Since November 1, 2008
Taiwan 7.00 [13]
Turkey 8.00 Since February 1, 2011
Jordan 8.00
Zambia 8.00
Burundi 8.50
Ghana 9.00
Israel 9.00 the Required Reserve Ratio is called Minimum Capital Ratio[14]
Mexico 10.50
Sri Lanka 8.00 With effect from 29 April 2011. 8% of total rupee deposit liabilities.
Bulgaria 10.00 Banks shall maintain minimum required reserves to the amount of 10% of the deposit base
(effective from December 1, 2008) with two exceptions (effective from January 1, 2009):
1. on funds attracted by banks from abroad: 5%;
2. on funds attracted from state and local government budgets: 0%.[15]
Croatia 14.00 Down from 17%, effective from 2009-01-14[16]
Costa Rica 15.00
Malawi 15.00
Nepal 5.00 From the monetary policy announcement for FY 2011/12 CRR reduced from 5.5% to 5%
Hong Kong 18.00
Brazil 20.00 Up from 15%, effective from 2010-12-06 - Ratio is for requirement on term deposits.[17]
RRR for foreign currency positions increased to 43.00 on 2010 July 15 [4]
China 20.50 Ratio is for major Chinese Banks on 2012-02-24;[18] down from a 21.5% high in June 2011.
Small and medium-size banks have a lower rate of 18.50%.
Tajikistan 20.00
Suriname 25.00 Down from 27%, effective from 2007-01-01[19]
Lebanon 30.00 [5]

Historical changes reserve ratios

In some countries, the cash reserve ratios have decreased over time; in some countries they have increased:[20]

Country 1968 1978 1988 1998
United Kingdom 20.5 15.9 5.0 3.1
Turkey 58.3 62.7 30.8 18.0
Germany 19.0 19.3 17.2 11.9
United States 12.3 10.1 8.5 10.3
India[21] 3 6 10 10-11

(Ratios are expressed in percentage points.)

See also

References

  1. ^ Central Bank of Russia
  2. ^ "China moves to cool its inflation". BBC News. 2007-11-11.
  3. ^ http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf
  4. ^ a b c http://www.federalreserve.gov/monetarypolicy/reservereq.htm
  5. ^ Monetary Macroeconomics by Dr. Pinar Yesin
  6. ^ "Inquiry into the Australian Banking Industry, Reserve Bank of Australia, January 1991
  7. ^ <en> European Central Bank, minimum reserve requirements
  8. ^ "Minimum Reserve Ratio". Bank of Latvia. Retrieved 2010-12-29.
  9. ^ http://www.nbp.pl/homen.aspx?f=/en/onbp/informacje/polityka_pieniezna.html
  10. ^ http://www.bnr.ro/Reserve-requirements-3658.aspx
  11. ^ Central bank of Russia Required reserve ratio on credit institutions' liabilities to non-resident has been raised to 4.0%
  12. ^ [1] ndtv.com
  13. ^ Liquidity ratio and liquid reserves of deposit money banks. Data released by Taiwan's central bank in October 2010.
  14. ^ "Minimum capital ratio". Bank of Israel. Retrieved 2010-12-29.
  15. ^ "Ordinance No. 21 of the BNB on the Minimum Required Reserves Maintained with the Bulgarian National Bank by Banks". Bulgarian National Bank.
  16. ^ [2] (in Croatian)
  17. ^ Business week - Brazil reserve requirement raise
  18. ^ China cut the required reserve ratio (RRR) for all banks by 50bp http://www.fxstreet.com on Feb 22nd 2012
  19. ^ "Reserve base en Kasreserve". Centrale Bank van Suriname. Retrieved 2009-12-21.
  20. ^ IMF Financial Statistic Yearbook
  21. ^ http://www.rbi.org.in/scripts/chro_bankrate.aspx Reserve Bank of India

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