What are bank reserves?
– Bank reserves are the cash holdings that commercial banks maintain so they can meet depositors’ withdrawal requests and satisfy regulatory requirements. Reserves take two forms: physical cash held in a bank’s vault (vault cash) and balances kept at the central bank.
Key terms (defined)
– Reserve ratio (reserve requirement): the percentage of certain deposit liabilities a bank must hold as reserves.
– Required reserves: the minimum amount mandated by the central bank.
– Excess reserves: any reserves held above the required minimum.
– Bank run: a rapid, mass withdrawal of deposits by customers worried about a bank’s solvency.
– Liquidity Coverage Ratio (LCR): a regulatory metric that forces banks to hold enough high-quality liquid assets to cover 30 days of net cash outflows under stress.
Why reserves matter (functions)
– Meet withdrawals: provide immediate liquidity when customers draw funds.
– Safety buffer: reduce the chance of a bank run.
– Monetary policy tool: central banks can change reserve requirements or influence reserve levels to affect lending and money supply.
– Regulatory compliance: reserves are part of broader liquidity requirements (for example, the LCR under Basel III).
Historical and policy context (brief)
– The U.S. created the Federal Reserve in 1913 to provide national oversight of the money supply and reduce frequent bank panics. Over time the Fed’s responsibilities expanded, notably in the 1970s with a formal focus on price stability.
– Reserve ratios in the U.S. have varied historically, ranging from around 0% up to about 10% of specified deposits.
– Since 2008 the Fed began paying interest on reserves. That change, plus large liquidity injections after the 2008 crisis, led banks to hold unusually high excess reserves.
– In response to the COVID-19 shock, the Federal Reserve set reserve requirement ratios to zero percent effective March 26, 2020. Even with a zero reserve ratio, banks must still satisfy other liquidity rules such as the LCR.
Are bank reserves assets or liabilities?
– For a commercial bank, reserves are assets: they are cash or claims on the central bank that the bank can use.
– From the central bank’s balance sheet perspective, deposits held by banks (the reserves) are liabilities of the central bank.
How required reserves are calculated (formula and components)
– Basic formula:
Required reserves = Reserve ratio × Net transaction accounts
– Net transaction accounts typically include demand deposits, certain checking-like accounts, and automatic transfer accounts, adjusted for items such as balances due from other banks and cash in the process of collection.
– The Fed sets the reserve ratio; some central banks use reserve requirements as an active policy tool, while others rely more on interest rates and open market operations.
Where banks keep reserves
– Vault cash: physical currency kept on-site.
– Balances at the central bank: electronic deposits that are immediately available for settlement among banks and for withdrawals.
Liquidity Coverage Ratio (LCR) — short explanation
– The LCR requires banks to hold sufficient high-quality liquid assets (HQLA) to cover 30 days of estimated net cash outflows under a severe but plausible stress scenario.
– The LCR complements reserve requirements by ensuring banks can meet short-term outflows even if reserve requirements are low or zero.
Key factors that influence reserve needs
– Composition of deposit liabilities (more transaction deposits → higher required reserves).
– Regulatory rules (reserve ratio, LCR, other liquidity metrics).
– Economic cycle (banks often accumulate reserves during downturns and reduce them in expansions).
– Central bank policy (changing reserve ratios, interest paid on reserves, or other liquidity facilities).
– Cross-border and interbank settlement needs.
Checklist: How a retail bank ensures reserve compliance
1. Identify the deposit categories that count as net transaction accounts.
2. Calculate net transaction accounts (total relevant deposits − due from other banks − cash in collection).
3. Apply the current reserve ratio to compute required reserves.
4. Compare required reserves to existing reserves (vault cash + central bank balances).
5. If reserves < required, obtain liquidity (borrow from interbank market, use central bank facilities, or liquidate assets).
6. Monitor LCR and other liquidity metrics even if reserve ratio is zero.
7. Document policies and run stress scenarios regularly.
Worked numeric example
Assume:
– Reserve ratio = 3% (for illustration only)
– Total transaction deposits = $500 million
– Funds due from other banks = $20 million
– Cash in process of collection = $5 million
Step 1 — compute net transaction accounts:
Net transaction accounts = $500m − $20m − $5m = $475m
Step 2 — required reserves:
Required reserves = 3% × $475m = 0.03 × $475m = $
= $14.25 million.
Step 3 — assume available reserves (vault cash + reserve balances at central bank)
– Example A (excess-reserve case): vault cash = $10.0m; reserve balances = $6.0m → Available reserves = $16.0m
– Excess reserves = Available reserves − Required reserves = $16.0m − $14.25m = $1.75m
– Interpretation: the bank holds $1.75m more than the minimum; that buffer can cover unexpected outflows or be invested/liquidated as policy permits.
– Example B (shortfall case): vault cash = $8.0m; reserve balances = $4.0m → Available reserves = $12.0m
– Reserve shortfall = Required reserves − Available reserves = $14.25m − $12.0m = $2.25m
– Practical responses (illustrative, not advice): borrow in the overnight interbank market or from a central bank facility, sell/pledge liquid securities, or use intraday liquidity arrangements to cover the $2.25m shortfall.
Worked shortfall numeric action (illustration only)
– If overnight interbank funding rate = 1.5% per annum, and you borrow $2.25m for 1 day:
– Interest = 2.25m × 0.015 × (1/365) ≈ $92.47
Quick formulas (one-line reference)
– Net transaction accounts = Transaction deposits − Due to other banks − Cash in process of collection
– Required reserves = Reserve ratio × Net transaction accounts
– Available reserves = Vault cash + Reserve balances at central bank
– Excess (shortfall) = Available reserves − Required reserves (negative = shortfall)
Daily checklist for reserve managers
1. Recompute net transaction accounts using the latest deposit and clearing data.
2. Calculate required reserves with the current applicable reserve ratio (check jurisdictional rules).
3. Pull intraday balances: vault cash, reserve account balance (start-of-day and expected end-of-day).
4. Compare available reserves to requirement; compute excess or shortfall.
5. If shortfall: identify funding sources ranked by cost and speed (overnight interbank, central bank window, repo, liquidate securities).
6. If excess: decide whether to retain buffer or deploy into low-risk, liquid investments (consistent with policy).
7. Record actions, update forecasts, and run an end-of-day reconciliation.
8. Run regular stress scenarios (e.g., deposit run, market shock) to confirm contingency plans.
Common pitfalls and assumptions
– Reserve rules vary by jurisdiction; some places (including the U.S. since March 2020) set reserve requirements to zero, but liquidity needs still exist. Confirm current regulatory settings before using any numeric example.
– “Available reserves” here excludes items like cash-in-process-of-collection and interbank floats that are not eligible for meeting reserve rules. Jurisdictional definitions can differ.
– Overnight funding cost estimates assume unsecured borrowing for simplicity; secured funding (repo) or central-bank facilities will have different pricing and haircuts.
Quick governance checklist for policy documents
– Define eligible reserve components and treatment of intraday items.
– Specify target buffer (e.g., X% of required reserves or fixed dollar amount).
– List primary and secondary funding sources with activation triggers.
– Set reporting frequency and reconciliation procedures.
– Test procedures via tabletop exercises and quantitative stress tests at least quarterly.
Educational disclaimer
This is educational material, not individualized investment or bank-management advice. Actual reserve management must follow current law, regulator guidance, and the institution’s risk limits.
Sources and further reading
– Investopedia — Bank Reserve: https://www.investopedia.com/terms/b/bank-reserve.asp
– Federal Reserve — Reserve Requirements of Depository Institutions: https://www.federalreserve.gov/monetarypolicy/reservereq.htm
– Bank for International
Settlements — Research and publications on liquidity and reserves: https://www.bis.org
– International Monetary Fund — Foreign exchange reserves and reserve management: https://www.imf.org/en/Topics/foreign-exchange-reserves
– European Central Bank — Monetary policy and payment/settlement systems: https://www.ecb.europa.eu
– Bank of England — Prudential and liquidity guidance for banks: https://www.bankofengland.co.uk