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Rules established and enforced by the Federal Reserve System governing the amount of reserves (vault cash and Federal Reserve deposits) that banks must keep to back up their deposits. Reserve requirements help to maintain a stable banking system and ensure that banks are able to conduct day-to-day check-clearing and cash-withdrawal transactions. These requirements are also one of the three monetary policy tools that the Fed can use, in principle, to control the money supply. The other two are open market operations and the discount rate. Reserve requirements are Federal Reserve System rules that specify the reserves that banks must keep to back up outstanding deposits (especially checkable deposits). The Board of Governors is responsible for setting and adjusting reserve requirements within legal boundaries set by the Monetary Control Act of 1980.
The two bank assets that can be use to satisfy reserve requirements are vault cash and Federal Reserve deposits. Reserve requirements were originally imposed on commercial banks to help avoid bank failures and related problems when did not keep enough reserves to undertake daily banking activity, including meeting cash withdrawals and processing checks.
In principle, reserve requirements also can be used as a means of a controlling the money supply. An increase in the money supply can be achieved when the Fed lowers reserve requirements. A decrease in the money supply can be achieved when the Fed raises reserve requirements. However, in practice, reserve requirements are not very flexible used only in extreme circumstances as a tool of monetary policy. Their most important role is to provide structure and stability to the banking system.
Basic ProcessThe Federal Reserve System can use, in theory, reserve requirements as a monetary policy tool for controlling the money supply and interest rates. The process would work like this:
- First, after evaluating the state of the economy, the Fed determines whether the money supply needs to increase or decrease and by how much.
- Second, if the Fed wants to increase the money supply it lowers reserve requirements and if it wants to decrease the money supply it raises reserve requirements. The reserve requirements are set by the Board of Governors.
- Third, the higher or lower requirements mean commercial banks have to keep fewer or more reserves to back up deposits. If reserve requirements are higher, then banks have to keep more reserves. If reserve requirements are lower, then banks can keep fewer reserves.
- Fourth, the change in reserves that banks have to keep induces a change lending activity. If reserve requirements are higher, then banks have fewer reserves available for lending. If reserve requirements are lower, then banks have more reserves available for lending.
- Fifth, the change in bank lending affects the creation of checkable deposits, which are an important component of the money supply. More loans mean more deposits and an increase in the money supply. Fewer loans mean fewer deposits and a decrease in the money supply.
- Sixth, the change in bank lending also affects interest rates. If banks are willing to lend more, then interest rates fall. If banks are willing to lend less, then interest rates rise.
Lower or Higher, More or LessThe end result of a change in reserve requirements is a change in the money supply and a change in interest rates. Should the Fed decide that the economy is in or heading toward a recession, then it would be inclined to lower reserve requirements and implement expansionary monetary policy. If the Fed thinks the economy is overly stimulated with higher inflation setting in, then it would be likely to raise reserve requirements and implement contractionary monetary policy.
- Expansionary Monetary Policy: An increase the money supply and a reduction in interest rates results when the Fed lowers reserve requirements. This is the recommended monetary policy to counter a recession, to stimulate the economy, and to reduce the unemployment rate.
- Contractionary Monetary Policy: A decrease the money supply and a boost in interest rates results when the Fed raises reserve requirements. This is the recommended monetary policy to counter an overheated expansion, to put the brakes no the economy, and to reduce the inflation rate.
Regulating Fractional ReservesOne of the original and most important functions of the Federal Reserve System is to regulate the reserves held by banks (which is a key reason for the name Federal RESERVE System). The need for reserve regulation is intrinsic to the modern fractional-reserve banking system.
Fractional-reserve banking means that banks keep only fraction of deposits in reserve. That is, banks divide assets between non-interest-paying reserves and interest-paying loans (and other investments). This further means that banks have enough reserves available to cover only a fraction of deposits. Should too many customers seek to withdraw deposits, a bank can quickly deplete available reserves and be forced to close its doors.
Unfortunately if banks make any errors under fractional-reserve banking they are likely to keep too few reserves and make too many interest-paying loans. Before the creation of the Federal Reserve System banks frequently ran short of reserves, forcing temporary or even permanent closure, and on more than a few occasions, this triggered economy-wide bank panics and financial crises. The Fed was the established to address this problem, which it did in part through reserve requirements.
Regulation DThe Federal Reserve System authority to regulate bank reserves is contained in Regulation D (other regulations run through the alphabet from A to Z and even spill over into double letters AA to EE). The authorization of Regulation D was established by the Federal Reserve Act of 1913, and modified with other legislation, most notably the Monetary Control Act of 1980.
Under Regulation D, the Board of Governors of the Federal Reserve has the authority to impose reserve regulations on all depository institutions operating in the country, including traditional banks (national and state), savings and loan associations, credit unions, mutual savings banks, and even branches of foreign banks.
In the early years of the Fed, reserve requirements were imposed only on member banks--national banks and state banks that chose to join the Federal Reserve System. However, the Monetary Control Act of 1980 extended authority to all depository institutions, most notably savings and loan associations, credit unions, and mutual savings banks. This was done in large part to ensure uniformity among all depository institutions that issued checkable deposits and thus create a banking system and money supply that were more effectively controlled through open market operations.
Modern RequirementsThe Monetary Control Act of 1980 and Regulation D give the Board of Governors the ability to set reserve requirements on net transactions deposits (checkable deposits), time deposits (savings deposits and certificates of deposit), and Eurocurrency (Eurodollars). The Board can adjust requirements within boundaries set by the Monetary Control Act (up to 14 percent for net transactions deposits and up to 9 percent for time deposits).
Time deposits and Eurocurrency are subject to a 0 percent reserve requirement (that is, no reserves are required to back up these deposits). This has not always been the case and can change if the Fed so decides.
Net transactions deposits are subject to a three-tiered set of requirements. While the actual tiers change based on inflation, the first $7 million (or so) of deposits have a 0 percent reserve requirement, the next $40 million (or so) of deposits (termed the low reserve tranche) is subject to a 3 percent reserve requirement, and any deposits over $46 million (or so) of deposits is subject to a 10 percent reserve requirement.
The lowest tier means that banks are given a "free pass" on reserve requirements for the first $7 million (or so) of deposits, essentially excluding the very smallest depository institutions from the need to keep reserves. Slightly larger banks are then subject to modest 3 percent reserve requirements for deposits exceeding $7 million. The largest banks enter into the highest tier with reserve requirements of 10 percent.
Banks have some degree of flexibility in meeting reserve requirements. First, banks only need to satisfy requirements over a 2-week reporting period rather than each day. Second, banks have a 4 percent carry over margin (plus or minus) from one reporting period to the next.
The Board of Governors, after consulting with Congress, can also set reserve requirements outside the boundaries set by the Monetary Control Act. These emergence requirements can be in place for up to 180 days.
Making It Work For Monetary PolicyIn theory, reserve requirements can be adjusted periodically as a monetary policy tool to control the money supply and interest rates. In practice, the Fed prefers to use open market operations and the discount rate. However, reserve requirements do play an key role (actually three related roles) in the conduct of monetary policy.
- One, reserve requirements create a stable banking structure that helps the Fed control the money supply more effectively. Reserve requirements determine the magnitude of the deposit expansion multiplier and how much the Fed needs to change reserves to achieve a given change in the money supply.
- Two, the Board of Governors does have the discretion to impose supplemental reserve requirements of 4 percentage points on depository institutions if intended for monetary policy, just the thing that might be needed to fight inflation. The Fed pays interest on these supplemental reserves and must review the decision after one year to see if it is still needed.
- Three, because reserve requirements are more important to the structure of the banking system than to the conduct of monetary policy, when they are changed, the Fed generally offsets any disruptions with open market operations or the changes are timed to reinforce a major redirection of monetary policy.
Two Other ToolsThe reserve requirements are one of three tools that the Fed can use, in theory, to control the money supply. The other two are the open market operations and the discount rate.
- Open Market Operations: The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.
- Discount Rate: The Fed can adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.
RESERVE REQUIREMENTS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 4, 2024].
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