is a companion to Money
Basics. It presents a more detailed treatment of
reserve banking and its relation to the money supply.
All depository institutions -- commercial banks and
thrifts -- in the
United States are subject to reserve requirements on customer deposits.
The required reserve ratio depends on the amount of checkable deposits
a bank holds. No reserves are required on the first $12.4
Between $12.4 million and $79.5 million, deposits are subject to a 3%
Above $79.5 million they are subject to a 10% reserve. These
breakpoints are effective year-end 2012, and are adjusted annually in
with money supply growth. No reserves are required against time
or savings accounts.
Reserves are figured as the average held over a 14-day
every second Wednesday. On any single day, a bank needs only
to cover its customer's withdrawals. A bank may hold its reserves
in any combination of vault cash and deposits at the Fed. As
enterprises, banks try to keep their reserves close to the required
since they earn no interest.
How Banks Meet Reserve
A bank loses reserves whenever it pays out cash or
transfers funds by
wire for its customers. Customer checks to pay out of town bills
funnel back through the Fed and are charged against its reserves.
A bank may also lose reserves when it advances loans or buys
Conversely a bank gains reserves when it receives new deposits.
A bank facing a reserve deficiency has several
options. It can
try to borrow reserves for one or more days from another bank; sell
assets, such as government securities; bid for funds in the money
such as large CDs or Eurodollars; or as a last resort it can pledge
and borrow at the Fed’s discount window.
An active market in reserves acts to redistribute
reserves to those
banks that need them. However banks cannot create reserves
If the aggregate demand exceeds the existing supply of non-borrowed
the banking system as a whole has no alternative but to borrow more
from the Fed.
Factors Affecting Aggregate
There are many factors outside of the Fed’s control that
level of non-borrowed reserves. They include changes in currency
holdings of the public, changes in the Treasury’s cash balances at the
Fed, checking system float, and foreign central bank
The Fed actively compensates for these variations by adding or draining
system reserves as needed to avoid large fluctuations in their market
i.e. the Fed funds rate. Over time, the growing demand for
is the largest single factor requiring reserve injections.
The Treasury holds working balances at the Fed for
making payments on
behalf of the government. Drawing down those balances increases
banking system reserves since it results in a transfer of funds to the
banking system. In order to minimize variations in total banking
system reserves due to its own spending, the Treasury targets a fixed
of $5 billion at the Fed by transferring funds as required from its
Tax & Loan accounts at commercial banks. TT&L accounts
as collection points for receipts from taxes and the sale of
and are reserves of the banking system.
Many foreign central banks keep working balances at the
Fed to execute
their dollar-denominated transactions. Drawing down of those
increases the reserves of depository institutions receiving
Transfers can sometimes result in significant increases or decreases in
reserves, requiring offsetting open market operations by the Fed.
How the Fed Manages Reserves
The Fed adjusts aggregate banking
system reserves through
short term transactions with security dealers, primarily repurchase
involving Treasury debt. Occasionally the Fed purchases Treasury
debt outright, which then becomes a permanent addition to the monetary
base. If necessary the Fed could sell Treasury debt from its
but that seldom happens in a growing economy.
Size and Composition of the
As of July 2007, the monetary base created by the
Fed totaled $836
billion. Of that total, $758 billion consisted of Federal Reserve notes
and coins held by the public. The Fed estimates that more than
of the currency is overseas, mostly owned by foreigners. Federal
Reserve notes are prized as a store of value and used as a medium of
in those countries where the local currency is not trusted.
The remainder of the monetary base comprises the
reserves of depository
institutions (commercial banks and thrifts). Those reserves
a multiple of bank money created through the act of lending.
Linkage Between Reserves and
In practice, reserves bear almost no relation to the
size of the money
supply. Indeed in the 10-year period from July 1997 to July 2007,
while the M2 money aggregate increased by 84%, total banking system
by 10%. The explanation for this anomaly is due in part to
banking. Through the use of overnight sweep accounts, banks can
substantial amounts of deposits out of the reservable category without
affecting customer access to their checkable funds.
While this seems to violate the intent of the Fed’s
it does not materially affect the implementation of monetary
Banks must still attend to their reserve ratios, and hold adequate
balances at the Fed. That creates an active money market in Fed
whose price the Fed can control through its open market