Reserve requirement

The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank.

The reserve ratio is sometimes used as a tool in monetary policy, influencing the country's economy, borrowing, and interest rates. [http://www.cbr.ru/eng/analytics/standart_system/print.asp?file=policy_e.html] Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy. The People's Bank of China does use changes in reserve requirements as an inflation-fighting tool, [http://news.bbc.co.uk/1/hi/business/7089307.stm] and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), 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".

Effects on money supply

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the change in excess reserves of $90 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000), e.g.$100/0.10=$1,000. In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of ($100+$80+$64+$51.20+...=$500), e.g.$100/0.20=$500. Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits such as CDs, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

Reserve ratios

A "cash reserve ratio" (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the "cash asset ratio" or "liquidity ratio". In the United States, the Board of Governors of the Federal Reserve System requires zero percent (0%) fractional reserves from depository institutions having net transactions accounts of up to $9.3 million. [ [http://www.federalreserve.gov/pubs/supplement/2008/02/table1_15.htm Reserve Requirements of Depository Institutions in February 2008 Statistical Supplement to the Federal Reserve Bulletin, Table 1.15] ] Depository institutions having over $9.3 million, and up to $43.9 million in net transaction accounts must have fractional reserves totaling three percent (3%) of that amount. [ [http://www.federalreserve.gov/pubs/supplement/2008/02/table1_15.htm Reserve Requirements of Depository Institutions in February 2008 Statistical Supplement to the Federal Reserve Bulletin, Table 1.15] ] Finally, depository institutions having over $43.9 million in net transaction accounts must have fractional reserves totaling ten percent (10%) of that amount. [ [http://www.federalreserve.gov/pubs/supplement/2008/02/table1_15.htm Reserve Requirements of Depository Institutions in February 2008 Statistical Supplement to the Federal Reserve Bulletin, Table 1.15] ] However, under current policy, these numbers do not apply to time deposits from domestic corporations, or deposits from foreign corporations or governments, called "nonpersonal time deposits" and "eurocurrency liabilities," respectively. For these account classes, the fractional reserve requirement is zero percent (0%) regardless of net account value. [ [http://www.federalreserve.gov/pubs/supplement/2008/02/table1_15.htm Reserve Requirements of Depository Institutions in February 2008 Statistical Supplement to the Federal Reserve Bulletin, Table 1.15] ]

The Bank of England holds to a voluntary reserve ratio system. In 1998 the average cash reserve ratio across the entire United Kingdom banking system was 3.1%. 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 [Monetary Macroeconomics by Dr. Pinar Yesin [http://www.iew.unizh.ch/study/courses/downloads/lecture8_467.pdf] ] ):

In some countries, the "cash reserve ratios" have decreased over time (sourced from IMF Financial Statistic Yearbook):(Ratios are expressed in percentage points.)

ee also

*Bank regulation
*Capital Requirement
*Fractional-reserve banking
*Full-reserve banking
*Islamic banking
*Monetary policy of central banks
*Money creation
*Money supply
*Reserves

External links

* [http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html Reserve Requirements - Fedpoints - Federal Reserve Bank of New York]
* [http://www.federalreserve.gov/monetarypolicy/reservereq.htm Reserve Requirements - The Federal Reserve Board]

Articles

* [http://www.hussmanfunds.com/html/fedirrel.htm Hussman Funds - Why the Federal Reserve is Irrelevant - August 2001]
* [http://www.islamic-finance.com/item113_f.htm Don't mention the reserve ratio]

Notes

For India, you can refer the following link:

http://rbi.org.in/scripts/AnnualReportPublications.aspx?Id=731