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Statistics for Business and Economics13th EditionDavid R. Anderson, Dennis J. Sweeney, James J Cochran, Jeffrey D. Camm, Thomas A. Williams 1,692 solutions What Are Reserve Requirements?Reserve requirements are the amount of cash that banks must have, in their vaults or at the closest Federal Reserve bank, in line with deposits made by their customers. Set by the Fed's board of governors, reserve requirements are one of the three main tools of monetary policy—the other two tools are open market operations and the discount rate. On March 15, 2020, the Federal Reserve Board announced that reserve requirements ratios would be set to 0%, effective March 26, 2020. Prior to the change effective March 26, 2020, the reserve requirement ratios on net transactions accounts differed based on the amount of net transactions accounts at the institution. Key Takeaways
Understanding Reserve RequirementsBanks loan funds to customers based on a fraction of the cash they have on hand. The government makes one requirement of them in exchange for this ability: keep a certain amount of deposits on hand to cover possible withdrawals. This amount is called the reserve requirement, and it is the rate that banks must keep in reserve and are not allowed to lend. The Federal Reserve's Board of Governors sets the requirement as well as the interest rate banks get paid on excess reserves. The Financial Services Regulatory Relief Act of 2006 gave the Federal Reserve the right to pay interest on excess reserves. The effective date on which banks started getting paid interest was Oct. 1, 2011. This rate of interest is referred to as the interest rate on excess reserves and serves as a proxy for the federal funds rate. The reserve requirement is another tool that the Fed has at its disposal to control liquidity in the financial system. By reducing the reserve requirement, the Fed is executing an expansionary monetary policy, and conversely, when it raises the requirement, it's exercising a contractionary monetary policy. This latter action cuts liquidity and causes a cool down in the economy. Reserve Requirements HistoryThe practice of holding reserves started with the first commercial banks during the early 19th century. Each bank had its own note that was only used within its geographic area of operation. Exchanging it to another banknote in a different region was expensive and risky because of the lack of information about funds at the other bank. To overcome this problem, banks in New York and New Jersey arranged for voluntary redemption at each other's branches on condition that the issuing bank and redeeming bank both maintained an agreed upon deposit of gold or its equivalent. Subsequently, the National Bank Act of 1863 imposed 25% reserve requirements for banks under its charge. Those requirements and a tax on state banknotes in 1865 ensured that national bank notes replaced other currencies as a medium of exchange. The creation of the Federal Reserve and its constituent banks in 1913 as a lender of last resort further eliminated risks and costs required in maintaining reserves and pared-down reserve requirements from their earlier high levels. For example, reserve requirements for three types of banks under the Federal Reserve were set at 13%, 10%, and 7% in 1917. In response to the COVID-19 pandemic, the Federal Reserve reduced the reserve requirement ratio to zero across all deposit tiers, effective March 26, 2020. The aim of this reduction was to jump-start the economy by allowing banks to use additional liquidity to lend to individuals and businesses. Dec. 23, 1913The day President Woodrow Wilson signed the Federal Reserve Act into law, thus creating the Federal Reserve. Reserve Requirements vs. Capital RequirementsSome countries don't have reserve requirements. These countries include Canada, the United Kingdom, New Zealand, Australia, Sweden, and Hong Kong. Money can't be created without limit, but instead, some of these countries must adhere to capital requirements, which is the amount of capital a bank or financial institution must hold as required by its financial regulator. Example of Reserve RequirementsAs an example, assume a bank had $200 million in deposits and is required to hold 10%. The bank is now allowed to lend out $180 million, which drastically increases bank credit. In addition to providing a buffer against bank runs and a layer of liquidity, reserve requirements are also used as a monetary tool by the Federal Reserve. By increasing the reserve requirement, the Federal Reserve is essentially taking money out of the money supply and increasing the cost of credit. Lowering the reserve requirement pumps money into the economy by giving banks excess reserves, which promotes the expansion of bank credit and lowers rates. Who Sets the Reserve Requirement?In the United States, the Federal Reserve Board sets the reserve requirements. The Federal Reserve Board receives its authority to set reserve requirements from the Federal Reserve Act. The Board establishes reserve requirements as a way to carry out monetary policy on deposits and other liabilities of depository institutions. What Does a Lower Reserve Requirement Mean?A lower reserve requirement means the Federal Reserve is pursuing an expansionary monetary policy. The lower reserve requirement means banks do not need to keep as much cash on hand. This gives them more money for consumer and business loans. What Does a Higher Reserve Requirement Mean?A higher reserve requirement means the Federal Reserve is pursuing a contractionary monetary policy. If banks have a higher reserve requirement, there will be less money available to lend to consumers and businesses. However, this money will then provide the banks with a level of protection against possible bank failure should there be an economic downturn or a run on the bank. Correction—November 26, 2021: A previous version of this article misstated the date when the Federal Reserve began paying banks interest on excess reserves. How can Bank Runs be prevented?Preventing Bank Runs. Slow it down. Banks may choose to shut down for a period of time if they are faced with the threat of a bank run. ... . Borrow. Banks may borrow from other institutions if they don't have enough cash reserves. ... . Insure deposits.. How does the Federal Reserve prevent runs on banks quizlet?The problem is that bank runs can cause solvent banks to fail and spread to the rest of the financial system. To prevent this, the Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else. This is known as the lender of last resort role.
How does the Fed control the money supply?The Fed can influence the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.
What does the Federal Reserve bank do?Supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
Who is the Fed accountable to?The Fed is an independent government agency but accountable to the public and Congress. The chair and Board of Governor's staff testify before Congress and submit a Monetary Policy Report twice a year. Independently audited financial statements and FOMC meeting minutes are public.
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The Fed can directly protect a bank during a bank run by
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