How to Define Monetary Policy Reserve Requirements
Reserve requirements are national policy regulations that require banks and other depository institutions to maintain a certain minimum value of assets in cash and very short-term liquid obligations. Reserve requirements are deemed crucial to the maintenance of a stable banking system in a country and also serve a key role in the setting of a nation's monetary policy.
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Features
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In order to maintain a stable financial sector, most nations mandate that depository institutions, such as banks and savings and loans institutions, hold a percentage of customer deposits in cash -- notes and coins -- or other very short-term, highly liquid instruments. Most typically, these very short-term, highly liquid instruments will consist of deposits with the nation's central bank, although they may include highly secure overnight loans or certain repurchase agreements.
Function
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The policy of mandating reserve requirements is intended to maintain order in the banking sector in the case of investor panic or financial crisis. Reserve requirements ensure that banks have sufficient funds immediately available in case a large number of depositors wish to withdraw their cash at once. The policy ensures sufficient liquidity in order to prevent bank runs, where numerous panicked depositors all try to withdraw cash before the bank depletes its reserves.
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Significance
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Banks and other depository institutions would prefer to keep as small a portion of their assets as possible in cash and extremely short-term instruments. These instruments yield little or no return to the bank, which would rather invest them in longer-term, riskier instruments that would return more interest income to the bank. In economics, this is often referred to as the "reserve requirement tax." Banks, forced to keep reserves in cash, see the real value of these cash holdings eroded by inflation. As inflation increases, so does the cost of holding cash in reserve.
Effects
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The reserve requirement has significant implications for a nation's monetary policy. Reserve requirements are a key determinant of an economy's money multiplier, or the way in which banks can expand a nation's monetary base through lending. In brief, the lower a bank's reserve requirement, the more money that bank can lend to customers, thus affecting an economy's money supply, interest rates and aggregate borrowing. For example, a bank with a 5-percent reserve requirement can lend 95 percent of its deposits to customers, while a bank with a 15-percent reserve requirement can only lend 85 percent of its deposits to customers.
Warning
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In 2007 and 2008, the collapse of several major banks and financial institutions was deemed a financial crisis. Several banks -- most notably Northern Rock in Britain -- held insufficient reserves and suffered bank runs. In the wake of this crisis, financial regulators are faced with a dilemma. While increasing bank reserve requirements helps to ensure stability and prevent future crises, it also has the effect of diminishing a nation's money supply, raising interest rates and enfeebling a nation's economic recovery.
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References
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