Bank Reserve Definition Impact Of Inflation On Bank Reserves

What is Bank Reserve?

Classification

It can be classified into the required reserveRequired ReserveReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more and the excess reserveExcess ReserveExcess reserves are kept or deposited with the central regulatory authority over and above the statutory requirements. If reserves are positive, the bank has held the amount in reserves more than the statutory requirement. In the case of zero value, there is no deficit or surplus reserves balance kept.read more.

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#1 – Required Reserve

The required reserve is the minimum fund banks must hold to meet their deposit liabilities. The Fed has the authority to make changes in the required reserve ratio percentage from time to time.

The Fed has updated its required reserve target ratio, which is applicable from January 17, 2019. The updated limits are as follows

(Source: federalreserve.gov)

As per the latest requirements, all the banks having deposit liabilities valuing more than the US $ 16.30 million but less than the US $ 124.20 million must keep 3% of deposits as a required reserve. The banks with deposit liabilities of more than US $ 124.20 million must maintain a required reserve equal to 10% of deposit values.

Further, while calculating the required reserve, the banks consider the net transaction accounts, which means they do not consider the funds due from other banks or transactions that are still outstanding.

#2 – Excess Reserve

The excess reserve is the cash required to keep in the vault over the minimum required reserve. Usually, the banks keep the excess reserve balance at lower levels and lend out the money instead of keeping it in vaults. This is mainly because banks can earn higher returns by lending the funds as compared to the rate of interest offered by the Fed. In the past, the incentives to maintain the excess reserve balances were very low or near zero. However, the excess reserve balance can pile up during crisis scenario financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more that happened in 2008, the Fed reduced the reserve target ratios to the lowest possible ceiling in order to stimulate the lending and to initiate economic recovery. However, in 2008, even after the lowest reserve requirements, the banks were not ready to lend due to a high volume of bad debts, and they want to utilize the available cash realized from the reserve holding toward the writing off the bad debts.

During the 2008 crisis, the aggregate of the excess reserves of all the banks shot up to US $ 1.25 trillion (as reported in the Federal Reserve Statistical Release H.3), and the liability side of the Fed’s Balance Sheet increased due to increased reserve balances.

Instead of allowing the banks to use the funds to write offWrite OffWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more the bad debt, the fed made a change in its policy in October 2008 and started paying interest on the reserve funds. The interest rate offered was fluctuating with the monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more. This unconventional move allowed the Fed to take control of the money market securitiesMoney Market SecuritiesThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more and short term interest rates.

Interest Rate on Bank Reserves

The Fed determines the interest rate on required reserves (IORR) and the Interest rate on Excess reserves (IOER). These interest rates get updated each business day at 4:30 pm EST with the interest rate for the next business day.

The latest published interest rate is as follows:

Impact of Inflation

During inflation, the demand for goods and services surpasses the available supply at current prices. This demand-supply gap leads to an increase in prices and causes inflation. To deal with the scenario, the Fed begins to pay higher interest on the excess reserve, which affects the lending growth as a guard against inflationary pressure.

When a Fed raises the interest rate on excess reserves, the banks become more willing to keep the cash in the vault instead of lending it out, which affects the purchasing power of the consumers and hence the recovery beings to establish equilibrium.

However, when the economy goes through the problem of deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more (i.e., when the supply of the goods and services produced is higher than the demand), the fed reduces the interest rate almost to zero. This encourages the lending process resulting in an increase in the purchasing power of the end-users.

Conclusion

Bank reserves are the minimum amount of funds held by the banks in cash or vault to ensure regulatory compliance with the federal reserve bank. The key purpose is to regulate the banking procedure and ensure that banks will not go short of funds if any demand liability arises.

What is Bank Reserve?#

Classification#

#1 – Required Reserve#

#2 – Excess Reserve#

Interest Rate on Bank Reserves#

Impact of Inflation#

Conclusion#

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