The concept of bank reserves is a simple one, however there is definitely some nuance to it. Typically, bank reserves are thought of as cash held by a commercial bank to back their deposits and other liabilities, sometimes even as physical cash stored in a vault at their locations. While there is some vault cash held by banks that are counted towards their bank reserves, the vast majority of bank reserves are just a number in the bank’s reserve account at the federal reserve. This digital money in the bank’s reserve account, their vault cash, and their service-related deposits are used to “back” the bank’s reservable liabilities, which include transaction accounts and nonpersonal time deposits, amongst other things.
Some clarification of the above to charts is in order. The first chart is of the total amount of reserves held by depository institutions at the Fed. The second is similar but excludes the reserves held in the form of vault cash and service-related deposits. As can be seen, they are very similar in form, with the vertical scale being the same for both charts. The second seems a bit elongated, but this is due to the time scale starting in the early 1980s rather than before 1960 as the first one does. Before 2008, it seems as if the amount of bank reserves was zero, it wasn’t. The amount of bank reserves in 2008 was around $40 billion, so as can be seen, in late 2020 and 2021 the amount had increased to over $4 trillion, that is a hundred times increase.
How Bank Reserves Work
In a fractional reserve banking system, bank reserves are necessary to back the liabilities of the bank in the case of a bank run or a currency drain. Essentially, the bank would need to have cash to service the withdraws of their depositors and the settlements between other banks. But is that really what they are used for today? This is a question that should be asked because the reserve requirement has been at 0% since 2020, therefore, does the United States even operate in a fractional reserve banking system anymore? There are some good arguments that no, we do not have a fractional reserve banking system, and may not have been for quite some time.
Regardless of this, how are bank reserves used today? Bank reserves are an asset of the commercial bank, and a liability of the federal reserve. The Fed can simply conjure up bank reserves in the reserve accounts of the commercial banks, exactly how the commercial banks conjure up deposits when they produce loans. With this in mind, bank reserves are simply a liquid instrument used as money between depository institutions. This means they are used as a unit of account between the banks themselves for their lending and transactional purposes. Because of this function, the fed can influence these practices by changing the amount of bank reserves in the banking system, which is a way to conduct monetary policy. In other words, by changing the amount of bank reserves in the system, the Fed influences to lending behavior of banks and other financial institutions.
Digital v. Vault cash
Below is a chart of vault cash that satisfies the reserve requirements held by institutions. The first thing to note is the obvious patten in its movement (i.e., the spikes on a regular basis). Interestingly enough, almost all of the little peaks occur in the beginning of every calendar year, happening between very late December and mid-February. This leads one to believe that there is a very cyclical event specific to vault case to induce annual cycle. A second note to make is the overall trend, which is the steady increase over the decades. From just over $7 billion on January 8th, 1975, the increase in vault cash has been relatively linear, excluding the first large increase which shifted the whole line higher (November 1980) .
Bank Reserves aren’t as simple as they seem
There are other characteristics of bank reserves that induce some level of complexity that are worth mentioning. For example, any increase or decrease in the total transaction accounts are determined based off of the 12-month period starting on June 30th. Also, some of these requirements apply to all depository institutions, but others do not. The Board of Governors may impose reserve requirements outside the typical ratios (i.e., reserve requirement of 10%). Both these facts as well as many others can be found in Section 19 of the Federal Reserve Act, along with definitions of the terms they use, or at least, how they define them. When it comes to the Fed and other similar entities, it is important to read the fine print, including how exactly they define their terms because without being explicit these concepts are prone to misunderstanding.
https://www.federalreserve.gov/aboutthefed/section19.htm
Impact of Bank Reserves Today and Final words
There are quite a few interesting arguments about the fundamentals of the monetary system. My current curiosity is whether or not we are actually in a fractional reserve banking system anymore, and if we are not, when did that change? Textbooks state that we are, but how can we be if banks are no longer constrained by bank reserves? The fact that the reserve requirement is 0% and has been for a couple years gives credence to this argument. There is also the fact that the Fed has stated we will operate in an “ample reserves regime”, meaning that there are so many reserves in the system that any significant fluctuation will not affect short-term rates (their definition). For more on the ample reserves regime and what it means (click here).
So, if we are no longer in a fractional reserve banking system, did that end when the reserve requirement hit 0%? I am not quite sure because there are some arguments that state this happened much further into the past with the birth and development of the Eurodollar system. For that argument, at least for now, I will suggest the work of Jeff Snider, as he is where I originally heard this argument and definitely does it more justice.
To your wealth and future,
James Forsythe
Other Bank Reserve Related Posts
References
[1] Board of Governors of the Federal Reserve System (US), Reserves of Depository Institutions: Total [TOTRESNS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TOTRESNS, May 16, 2022.
[2] Board of Governors of the Federal Reserve System (US), Liabilities and Capital: Other Factors Draining Reserve Balances: Reserve Balances with Federal Reserve Banks: Week Average [WRESBAL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WRESBAL, May 17, 2022.
[3] Board of Governors of the Federal Reserve System (US), Vault Cash, Total (DISCONTINUED) [TLVAULT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TLVAULT, May 18, 2022.
[4] Board of Governors of the Federal Reserve System (US), Reserves of Depository Institutions, Nonborrowed [NONBORRES], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NONBORRES, May 17, 2022.
