Reserve Requirements - A Percentage Of A Commercial Bank's Cash That Is To Be Kept

In many countries, commercial banks are required to maintain reserve requirements. This means that banks have to deposit part of their funds in accounts with the central bank.

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Definition

Required reserves - a percentage of a commercial bank's cash that is to be kept (refers to the average monthly balance) on its account at the central bank. On the one hand, the system of required reserves ensures the solvency of commercial banks and, on the other hand, allows the central bank to regulate the amount of money in circulation.

Increasing the required reserve results in limiting the lending activity of commercial banks, while reducing it increases their lending activity. If such a reserve is, for example, 10%, it means that the bank must keep 10% of the monetary resources at its disposal on an account with the central bank.

Commercial banks hold cash on current accounts with the central bank for mutual settlements on a daily basis. Current accounts are also used to make payments with the central bank itself. In the past, depositing funds with the central bank was intended to ensure the solvency of commercial banks. Currently, this is not the most important goal. Modern commercial banks have huge assets and their own reserves that their solvency is not at risk. However, they are required to hold mandatory reserves. Each bank must maintain a reserve requirement on its account with the central bank.

Other information

Currently, the system of mandatory reserves as a tool to ensure the liquidity of banks is losing its importance and its role as a tool to regulate the credit potential of the banking sector is increasing. As a restrictive tool, the Monetary Policy Council may raise the required reserve rate, which will result in a larger part (than previously) of a given bank's assets having to be transferred to the central bank. On the other hand, lowering the required reserve rate results in retaining more assets in the vaults of commercial banks, which entails, among others, an increase in lending and stimulation of investment processes.

It should be remembered that the maintenance of mandatory reserves inconsistent with the established ratios is associated with penalty interest.

Factors determining the level of required reserves

In line with the reserve requirement policy, the central bank sets different reserve levels for different types of bank deposits. This results from the maturity dates of deposits and concerns the risk of their withdrawal. Therefore, AWIST deposits have a higher reserve requirement ratio than term deposits, which have a longer maturity. Other factors influencing the level of the indicator include:

• the legal nature of the depositor (legal or natural person),
• contribution height,
• depositor's place of residence.

Advantages and disadvantages of the required reserve ratio

In the event of an increase in the required reserve ratio, banks with lower but sufficient liquidity may experience financial difficulties. This is the disadvantage of this instrument. Compensatory purchases of short-term securities in these banks by the central bank are then necessary in order to replenish liquid reserves. The advantage of the reserve requirement is that its use affects the liquidity of banks without an immediate impact on market interest rates. The central bank may temporarily pursue several goals at the same time.

Source: Bankowość, investopedia.com