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October 16, 2018 

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FED PYRAMID: A simple little diagram that depicts the structure of the Federal Reserve System, which is in the shape of triangle (hence the not totally accurate term "pyramid"), with a large base that comes to a peak. The base of the pyramid contains thousands of commercial banks, which rests on a foundation of the millions of people who make up the nonbank public. The middle of the pyramid includes 37 Federal Reserve Banks, including 12 District Banks and 25 Branch Banks. Resting at the top of the pyramid is the Board of Governors, with the Chairman at the very, very top. The top also has two notable offshoots -- the Federal Open Market Committee and the Federal Advisory Council.

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REQUIRED RESERVES:

The reserves (vault cash and Federal Reserve deposits) that banks are required by government to keep to back up deposits. The primary use of required reserves is to process daily checkable deposit transactions. The government regulator in charge of setting reserve requires is the Federal Reserve System. Required reserves are usually in the range of 3 to 10 percent for checkable deposits and substantially less (0 percent) for savings deposits. Any legal reserves held by banks over those required to back deposits, termed excess reserves or free reserves, are available for interest-generating loans.
Required reserves are the legal reserves that the Federal Reserve System requires that banks keep readily available to conduct daily transactions, especially to process checks, and to generally back up deposits.

While banks have a number of different assets that could, in principle, be used as reserves to back deposits, those that can be legally used to satisfy reserve requirements are vault cash and Federal Reserve deposits, both of which are commonly used to facilitate daily deposit transactions.

Any legal reserves held by banks over those needed to satisfy requirements are termed excess reserves or free reserves. Whereas required reserves are used to maintain the safety and liquidity of deposits, excess reserves are used for interest and profit generating loans.

Fractional-Reserve Banking

The modern banking system relies on fractional-reserve banking. Banks keep a portion of deposits in reserve, usually less than five percent, to facilitate daily business transactions (cashing checks and the like). They then use the rest for loans or other interest-paying investments.

Fractional-reserve banking makes it possible for banks to pursue two activities simultaneously: (1) safely maintaining the liquidity of checkable deposits and a portion of the money supply and (2) acting as a financial intermediary to match up lenders (especially households depositing paychecks) and borrowers (especially businesses investing in capital goods).

The practice of fractional-reserve banking means that banks must balance the profitability of loans with the safekeeping of deposits. Tilting too far in the direction of loans jeopardizes the safety of deposits. Excessively emphasizing safekeeping limits profit. In either case, problems can emerge and banks can go out of business if a proper balance is not maintained.

The Federal Reserve System

The amount of reserves that banks are required to keep to back up deposits is specified by the Federal Reserve System. Much like retail stores keep products on their shelves, banks keep reserves in the course of operating. However, if history is any indicator, banks are prone to error on the side of making too many loans and keeping too few reserves.

This is where the Federal Reserve System (or the Fed) enters the picture. Established in 1913, the Federal Reserve System is the principal regulator of the U.S. bank system. As the word "Reserve" in the name suggests, the Fed places a great deal of emphasis on the reserves that banks have available to back up deposits. To this end, the Fed regulates the reserves through reserve requirements.

The Fed sets required reserves in large part to ensure that banks avoid the bankruptcy pitfalls that can emerge if they do not keep sufficient reserves. However, in principle, the Fed can also use required reserves to control monetary policy. By reducing required reserves, banks can make more loans and increase the money supply. By raising required reserves, banks can make fewer loans and decrease the money supply.

While such monetary policy actions are possible, in theory, they are seldom used. The Fed prefers other options, including open market operations or the discount rate, to control the money supply.

Running Through Some Numbers

The amount of reserves that the Fed requires banks to keep depends on the size of the banks and the amount of their checkable deposits. While the specific numbers are adjusted each year and the ratios are also subject to change, the numbers in the early 2000s were something like this: The first $6.6 million dollars of checkable deposits were exempt from required reserves--a reserve ratio of 0 percent. From $6.6 million to $45.4 million, the reserve ratio was 3 percent. For checkable deposits exceeding $45.4 million, the reserve ratio was 10 percent.

Suppose for example, that AmosWEB National Bank has $50 million in checkable deposits. Based on these reserve requirements, no reserves are needed for the first $6.6 million. The next $38.8 million (the difference between $45.4 million and $6.6 million) requires $1.164 million in reserves (3 percent of $38.8 million). The next $4.6 million (the difference between $50 million and $45.4 million) requires $0.46 million in reserves (10 percent of $4.6 million). As such, AmosWEB National Bank is required to keep $1.606 million in reserves to back up its $50 million in checkable deposits.

Legal and Excess

Required reserves are one of two uses of legal reserves. The other is excess reserves.
  • Legal Reserves: Legal reserves are simply the total amount vault cash and Federal Reserve deposits held by banks. While banks have a number of different assets that could, in principle, be used as reserves to back bank deposits, vault cash and Federal Reserve deposits are the only assets that are permitted by government regulations.

  • Excess Reserves: Any legal (or total) reserves over and above those required by regulators are excess reserves. These excess reserves are used for loans, which makes them exceedingly important to the banking industry. Because reserves, unlike loans, do not generate interest, add to revenue, or enhance profit, banks are prone to hold as few reserves as possible. Banks hold enough reserves to satisfy reserve requirements, because they are required by law. But they try NOT to hold excess reserves. Holding excess reserves means lost interest revenue.

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Recommended Citation:

REQUIRED RESERVES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: October 16, 2018].


Check Out These Related Terms...

     | bank reserves | legal reserves | excess reserves | fractional-reserve banking | full-reserve banking | no-reserve banking | vault cash | Federal Reserve deposits |


Or For A Little Background...

     | banks | banking | traditional banks | savings and loan associations | credit unions | mutual savings banks | thrift institutions | money | M1 | monetary economics | government functions | financial markets | liquidity |


And For Further Study...

     | money creation | Federal Reserve System | Federal Deposit Insurance Corporation | Comptroller of the Currency | central bank | monetary policy | bank panic | monetary aggregates | barter | reserve requirements | discount rate | open market operations |


Related Websites (Will Open in New Window)...

     | Federal Reserve System | Federal Deposit Insurance Corporation |


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