The Role of Bank Reserves

Adequate Reserves Do Not Imply Solvency 

Reserves comprise funds on deposit at the Fed plus vault cash.   A bank can hold adequate reserves and still be insolvent if its total assets, including loans and securities, do not cover its liabilities.  However a bank in good standing can always borrow in the money market or at the Fed to meet its reserve requirements. 

The measure of a bank's solvency is its capital, i.e. assets minus liabilities.  The Fed imposes a lower limit on a bank's capital relative to its risk-weighted assets to provide a margin against insolvency.  That ratio is what ultimately limits a bank's deposit creation through lending. 

The Basic Function of Reserves 

Even with no minimum reserve requirement, banks would still have to hold enough reserves at the Fed to cover the checks written by their depositors, and enough vault cash to meet the demand for currency.  The Fed and other clearing banks typically require payment in reserve money which bears no credit risk, rather than direct transfers between private banks which do bear a credit risk. 

Other Useful Functions 

Reserve requirements in conjunction with an averaging period for reserve maintenance can provide a useful buffer against disturbances in the money market.  For example, if there were an unexpected fall in a bank's reserves early in the maintenance period, the bank could allow its reserves to fall below the required amount temporarily.  Later it could hold an excess sufficient to restore the required average level. 

In the long run, reserve requirements can also influence the level of bank lending, deposit rates, and the quantity of credit and deposits.  The key questions to be decided are:  what level of reserves to require, whether they are remunerated (receive interest), and whether they can be averaged over some specified period of days. 

The Trend Toward Zero Reserves

Unremunerated reserves are an implicit tax on banks, but it is their customers who ultimately pay.  The interest rate a bank charges on loans must reflect its operating costs.

In the U.S., the required reserve ratio is currently set at 10%; no interest is paid on reserve balances; and the averaging period for computing reserves is 14 days.  These rules are by no means typical among central banks.  Indeed the trend among leading industrial nations has been toward zero reserve systems. 

A Zero Reserve System

As an example, Canada imposes no minimum reserve on its banks.  Its central bank, the Bank of Canada (BOC), freely lends overnight at its so-called bank rate to ensure that payment orders between banks will clear.  That sets an upper limit on overnight rates.  It also pays interest on any clearing balances that banks hold at the BOC at a rate 0.5 percentage point below the bank rate.  That sets a floor on overnight rates.  Volatility in the money market rate is effectively limited to within this operating range. 

The BOC target rate is the midpoint of the range.  In order to steer the overnight rate toward its target, the BOC conducts open market operations similar to those used by the Fed.  To compensate for variations in clearing balances caused by federal government inflows and outflows, on a daily basis the BOC offers to buy or sell government balances at the BOC on an auction basis to a select group of securities dealers.

Is the U.S. Dollar a Special Case?

Whether the U.S. would be better served with a zero reserve system is not a simple issue.  An obvious advantage would be the removal of the tax on U.S. banks.  That would improve their competitive position world-wide.  But the role of the U.S. dollar as the primary world reserve currency must also be considered.  At the typically high level of U.S. dollar transactions, without an adequate cushion of reserves the number and size of bank overdrafts in Fed funds could potentially cause serious problems.