What are primary reserves?
Primary reserves are the minimum amount of cash legally required to operate a bank.Primary reserves also include legal reserves housed at a Federal Reserve Bank or other correspondent bank. Uncashed checks are also included in this amount.
The legal primary reserve requirement may or may not be the binding constraint on banks’ ability to increase the supply of credit in the economy. Market conditions may require banks to simply hold more cash to avoid defaults.
Key points to remember
- Primary reserves are the legal minimum amount of reserves that a bank is required to hold on its deposits.
- The amount of reserves held by banks helps determine the total supply of money and credit in the economy.
- In the United States, the Federal Reserve makes reserve requirements one of its monetary policy tools, lowering the requirement to increase the money supply or increasing it to contract the money supply.
- Since March 2020, the Fed has lowered all reserve requirements to zero, but banks continue to hold reserves based on their own liquidity needs rather than a legal constraint.
Understanding Primary Reserves
When a customer deposits money with a bank, the bank is required to keep a certain fraction in reserve. Part of the deposits is held in reserve as cash, while the rest is lent to borrowers or invested in less liquid assets.
Primary reserves are set up to cover normal daily withdrawals and in particular large withdrawals or series of unexpected withdrawals. They serve as a defense against a substantial reduction in liquidity. These reserves should be kept more liquid than secondary reserves, which can be invested in marketable securities such as Treasury offers.
Primary reserves represent the base of the credit pyramid that makes up the overall money supply in the economy through the practice of fractional reserve banking. The vast majority of money in the economy consists of electronic or other accounting entries created out of thin air by banks when they lend deposits which they also hold on behalf of depositors. The Federal Reserve, acting in its capacity as regulator of the banking system, requires banks to keep a small percentage of customer deposits in the form of cash to pay for withdrawals, and banks are only allowed to lend out a fraction of the deposits they make. they receive. This hampers the ability of banks to simply create an infinite amount of fresh money, as well as an opportunity cost for banks to hold cash deposits with little or no return to the bank.
By increasing or decreasing the amount of primary reserves that banks are required to hold, the Federal Reserve can tighten or loosen credit conditions and the supply of money and credit available in the economy. Banks can also increase or decrease their own reserves within federal limits, depending on whether they need more or less liquidity. If many banks raise more liquidity at the same time to meet the demands of their depositors and other creditors by selling assets or liquidating loans, this can reduce the money supply and have repercussions for the whole economy, creating a credit crisis. On the other hand, if banks reduce all their reserves, they can rapidly increase the volume of credit available in the economy, but at the risk of triggering credit bubbles and, eventually, inflation or even a recession one day. once the bubbles burst.
However, beginning in March 2020, the Federal Reserve eliminated reserve requirements for all depository institutions to free up liquidity for banks to increase lending to businesses and households. For now, the Fed does not plan to reimpose reserve requirements in the future.
In effect, banks are only required to hold the cash reserves they believe they need to cover customer withdrawals and other liquidity needs and the Fed is not required to hold cash if they choose to do not do it. The only constraint on banks in this case is the risk that holding insufficient reserves could lead to bankruptcies or bank defaults if they do not hold enough cash to pay their depositors and other creditors.
Since the financial crisis of 2007-2008, this market constraint is in any case the mandatory reserve requirement for banks. Since 2008, banks have held trillions of dollars in combined excess reserves beyond the Fed’s reserve requirements.