Reserve requirement

Article in other languages:

• Povinné_minimální_rezervy
• Mindestreserve
• Coeficiente_de_caja
• Réserves_obligatoires
• 지급준비제도
• Rasio_kecukupan_modal
• 支払準備率操作
• Depósito_compulsório
• Норма_обязательных_резервов
• Kapitaltäckning
• 銀行存款準備金比率

The reserve requirement (or required reserve ratio or cash reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. It would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank.

The reserve ratio is sometimes used as a tool in the monetary policy, influencing the country's economy, borrowing, and interest rates.[2] Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy. The People's Bank of China uses changes in reserve requirements as an inflation-fighting tool,[3] and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), and zero on time deposits and all other deposits.

An institution that holds reserves in excess of the required amount is said to hold excess reserves.

Effects on money supply

MS = MB * mm

mm = (1 + c) / (c + R)

MS = Money Supply

Mb = Monetary base

mm = money multiplier

c = rate atwhich people hold cash (as apposed to depositing it)

R = the reserve requirement (the percent of deposits that banks are not allowed to lend)

if banks only have to hold 10% of deposits,they will lend the other 90% of deposits. The person with that loan will then choose to deposit the money from the loan back into the bank at a rate of 'c' (for simplicity say c=0%.) then the bank can again loan 90% of the second deposit which was 90% of the first deposit.

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the change in excess reserves of $90 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000), e.g.$100/0.10=$1,000. In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of ($100+$80+$64+$51.20+...=$500), e.g.$100/0.20=$500. Thus, higher reserve requirements reduce artificial money creation and help maintain the purchasing power of the currency in use.

Reserve requirements in the US apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits such as CDs, have no reserve requirements and therefore can expand without regard to reserve levels.

Because of the volatile changes that reserve requirements have on the money supply, and their relative ineffectiveness in today's banking systems, the Federal reserve does not use reserve requirements as an economic tool.

Reserve ratios

A cash reserve ratio (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the cash asset ratio or liquidity ratio. In the United States, the Board of Governors of the Federal Reserve System requires zero percent (0%) fractional reserves from depository institutions having net transactions accounts of up to $9.3 million.^[1] Depository institutions having over $9.3 million, and up to $43.9 million in net transaction accounts must have fractional reserves totaling three percent (3%) of that amount.^[1] Finally, depository institutions having over $43.9 million in net transaction accounts must have fractional reserves totaling ten percent (10%) of that amount.^[1] However, under current policy, these numbers do not apply to time deposits from domestic corporations, or deposits from foreign corporations or governments, called "nonpersonal time deposits" and "eurocurrency liabilities," respectively. For these account classes, the fractional reserve requirement is zero percent (0%) regardless of net account value.^[1]

The Bank of England holds to a voluntary reserve ratio system. In 1998 the average cash reserve ratio across the entire United Kingdom banking system was 3.1%. Other countries have required reserve ratios (or RRRs) that are statutorily enforced (sourced from Lecture 8, Slide 4: Central Banking and the Money Supply, by Dr. Pinar Yesin, University of Zurich (based on 2003 survey of CBC participants at the Study Center Gerzensee^[2]):

In some countries, the cash reserve ratios have decreased over time (sourced from IMF Financial Statistic Yearbook):

(Ratios are expressed in percentage points.)

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Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR)^[5], is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss ^[6] and are complying with their statutory Capital requirements.

Formula

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Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures.

Capital adequacy ratio is defined as

where Risk can either be weighted assets () or the respective national regulator's minimum total capital requirement. If using risk weighted assets,

≥ 8%.^[5]

The percent threshold (8% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator.

Two types of capital are measured: tier one capital (T₁ above), which can absorb losses without a bank being required to cease trading, and tier two capital (T₂ above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Use

Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's depositors or other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.^[5]

CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk.

Risk weighting

Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR.

Risk weighting example

Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting.

Bank "A" has assets totaling 100 units, consisting of:

• Cash: 10 units.
• Government bonds: 15 units.
• Mortgage loans: 20 units.
• Other loans: 50 units.
• Other assets: 5 units.

Bank "A" has deposits of 95 units, all of which are deposits. By definition, equity is equal to assets minus debt, or 5 units.

Bank A's risk-weighted assets are calculated as follows:

Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equity-to-assets of only 5%, its CAR is substantially higher. It is considered less risky because some of its assets are less risky than others.

Types of capital

The Basel rules recognize that different types of equity are more important than others. To recognize this, different adjustments are made:

1. Tier I Capital: Actual contributed equity plus retained earnings.
2. Tier II Capital: Preferred shares plus 50% of subordinated debt.

Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets may be 4%, while minimum CAR including Tier II capital may be 8%.

There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the jurisdiction.

See also

• Tier 1 capital
• Tier 2 capital
• Basel accords

References

External links

• Capital Adequacy Ratio at Investopedia.
• Capital Adequacy Ratio at The Reserve Bank of New Zealand's website.
• Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
• Reserve Requirements - The Federal Reserve Board
• Hussman Funds - Why the Federal Reserve is Irrelevant - August 2001
• Don't mention the reserve ratio

References

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