Congressional limits for bank reserves were first established in the Federal Reserve Act of 1913 and have been reset a number of times since, most recently in the Banking Act of 1980 and the Garn-St. Germain Depository Institutions Act of 1982. This most recent legislation provides that all depository institutions-savings banks, savings and loans, and credit unions, as well as all commercial banks, whether members of the Federal Reserve system or not-are subject to the Fed’s reserve requirements. As of 1995 each depository institution had to hold reserves (in the form of vault cash or deposits in a regional Federal Reserve bank) as follows:
1. Against demand deposits and other transactions accounts, reserves equal to:
- a. 3 percent of its first $52.0 million of demand deposits.
- b. 10 percent of its demand deposits in excess of that amount. The Fed can vary this latter percentage within a range of 8 to 14 percent, and under emergency circumstances it can go as high as 18 percent.
2. Against business-owned time and savings deposits, reserves are zero. The Fed can vary reserves against such deposits within a range of zero to 9 percent.
3. Finally, regardless of the above requirements, the first $4.3 million of reservable liabilities is exempt from reserve requirements. The Fed adjusts this $4.3 million figure upward annually by 80 percent of the annual percentage increase in total reservable liabilities in the country.
Lowering the required reserve ratio for demand deposits-for example, from 12 to 10 percent-does two things. First, it instantly and automatically increases banks’ excess reserves, since fewer reserves are now required against any given volume of demand deposits. A bank with demand deposits of $1,000 and reserves of $120 is all loaned up when the reserve requirement is 12 percent; lowering it to 10 percent suddenly provides $20 of excess reserves. More excess reserves, of course, enable banks to make more loans, buy more securities, and expand demand deposits.
In addition, lowering the required reserve ratio also increases the demand deposit expansion multiplier for the entire banking system. The multiplier-at least in its simple form-is the reciprocal of the required reserve ratio. The smaller the ratio, the larger its reciprocal. Thus a decrease in the required reserve ratio from 12 percent (or about one-eighth) to 10 percent (one-tenth) would raise the deposit expansion multiplier from about eight to ten.
Raising the required reserve ratio-for example, from 10 to 12 percent- would have the opposite effects. It would create reserve deficiencies, or at least reduce excesses, and lower the potential for multiple expansion. Putting banks into a deficit reserve position would force them to call in loans and sell securities, bringing about a reduction in demand deposits, while smaller excesses would at least restrain lending and deposit creation.
Since the same reserve requirements apply to nonmember as well as to member commercial banks, membership in the Federal Reserve system has become essentially irrelevant. The problem of dropouts from the Federal Reserve system that occurred during the 1960s and 1970s has been resolved. Banks can no longer escape the requirement to hold zero-interest-bearing reserves by leaving the system. Also, since the same requirements apply to thrift institutions as to commercial banks, the distinction between them-as far as reserves go-has become less important.
How crucial are reserve requirements for monetary policy? What would happen if the Federal Reserve eliminated reserve requirements entirely in order to increase bank profits?
Actually, even without formal reserve requirements the Fed would still be in business. Financial institutions would still need both cash to meet customer withdrawals and balances in the Fed to clear checks. As long as they have a demand for claims against the central bank, and as long as the central bank controls the supply of such claims, monetary policy can still work. While the Fed would lose one tool of monetary policy if it could no longer change reserve requirements, it could still influence the behavior of financial institutions.
There is one qualification: The size of the multiplier relationship between reserves and money supply might fluctuate considerably. This would make the job of controlling the money supply more difficult. Not impossible, but more difficult.