Saturday, September 26, 2009

Reserve requirements and excess reserve

Money creation by banks is made possible because the public readily accepts claim on bank deposits (mainly checks) in payment for goods and services. In addition, the law requires individual banks to hold only a fraction of the amount of deposits received from the public in cash or near-cash reserve, thus freeing up a majority of incoming funds for the making of loans and the purchasing of securities. We need to look more closely at these so-called reserve requirements bank must meet, since they play a key role in the money-creation process.
Under current federal law, banks and other depository institutions must hold reserves in cash or in deposit form behind their transaction accounts and time and savings deposits. These reserve requirements are linked to the size of the depository institution and require that a specified percentage of all incoming deposits must be placed either in an account at the Federal Reserve Bank in the region or as cash in the bank's vault. Vault cash and deposits at the Fed constitute a bank's holdings of legal reserves- those assets acceptable for meeting reserve requirements behind the public's deposits. In 1980, following passage of the depository institutions deregulation and Monetary Control Act, all deposit-type financial institutions (including commercial banks, mutual savings banks, savings and loan associations, and credit unions) were required to hold legal reserves equal to 3 percent of that portion of their transaction accounts (principally checking and NOW accounts) below $25 million and 12 percent for that portion over $25 million.
Each bank's legal reserve may be divided into two categories- required reserves and excess reserves. Required reserves are equal to the legal reserve requirement ratio times the volume of deposits subject to reserve requirements. For example, if a bank holds $20 million in checking and other transaction accounts and $30 million in savings deposits and the law requires it to hold 3 percent of its transaction accounts and 3 percent of its savings deposits in legal reserve , then required reserves for this bank are $20 million ×3%+$30 million×3 %,or $1.5 million.
Excess reserve equal the difference between the total legal reserves actually held by a bank and the amount of its required reserves. For example, if a bank is required to hold legal reserves equal to $1.5 million but finds on a given date that it has $500,000 in cash on the premises and $1.5 million on deposit with the Federal Reserve Bank in its region, this bank clearly holds $500,000 in excess reserves. Since legal reserve assets earn little or no interest income, most commercial banks try to keep their holdings of excess reserve as close to zero as possible. Indeed, the larger banks frequently run deficits in their required reserve position and must borrow additional legal reserves from other banks or attract more funds from their customers to cover the deficit.

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