Reserve requirement

Many textbooks describe a system in which reserve requirements can act as a tool of a country’s monetary policy though these bare little resemblance to reality and many central banks impose no such requirements. The commonly assumed requirement is 10% though almost no central bank and no major central bank imposes such a ratio requirement.

With higher reserve requirements, there would be less funds available to banks for lending. Under this view, the money multiplier compounds the effect of bank lending on the money supply. The multiplier effect on the money supply is governed by the following formulas:

${\displaystyle M_{1}={\mathit {MB}}\times m\,}$ : 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).

This limit on the money supply does not apply in the real world.[5]

Central banks dispute the money multiplier theory of the reserve requirement and instead consider money as endogenous. See 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.[6] 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.[6]

The Board of Governors of the Federal Reserve System sets reserve requirements[7] (“liquidity ratio”) based on categories of deposit liabilities ("Net Transaction Accounts" or "NTAs") of depository institutions, such as commercial banks including U.S. branches of a foreign bank, savings and loan association, savings bank, and credit union. The deposit liability categories currently subject to reserve requirements are mainly checking accounts, with no reserve requirement on savings accounts and time deposit accounts of individuals.[8] 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 reserve requirement for all deposit institutions was set to 0% of eligible deposits. The Board previously set 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 excess reserves held by them.[9][10]

Under the International Banking Act of 1978, the same reserve ratios apply to branches of foreign banks operating in the United States.[11][12]

The People's Bank of China uses changes in the reserve requirement as an inflation-fighting tool, and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010.

In the United Kingdom, commercial banks are called clearing banks with direct access to the clearing system.

The Bank of England, the central bank for the United Kingdom, previously set a voluntary reserve ratio, and not a minimum reserve requirement. 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.[14]

From 1971 to 1980, the commercial banks all agreed to a reserve ratio of 1.5%. In 1981 this requirement was abolished.[14]

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[14] 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).[15] 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.[14]^: 347

Australia abolished "statutory reserve deposits" in 1988, which were replaced with 1% non-callable deposits.[16]

The United States removed reserve requirements for nonpersonal time deposits and eurocurrency liabilities on Dec 27, 1990 and for net transaction accounts on March 27, 2020.[17]