Reserves are essential for Banks but excess holding of Reserves become problem for Banks and Customer both. Title of this project is-“Why Banks Are Holding Excess reserves.” Reserves are funds held by depositary institutions that can be used to meet the institution’s legal reserve requirement.
The quantity of reserves in the US banking system has risen dramatically. Some observers analyzed this effect and said-Federal Reserves policies have been failed for providing credits to household & firms. Others argued that the high level of reserves will be inflationary.
Some observers have expressed concern that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover. Meltzer (2009), for example, worries that “the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain.”
When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates. As banks lend more, new deposits will be created and the general level of economic activity will increase. Objective of this study is to understand the Bank’s credit terms and lending policies.
In this project study we are collecting data from secondary method of data collection. We are using Websites, Articles & Magazines.
After doing this study we would be able to understand that a large increase in Bank reserves need not be inflationary because the payment of interest on reserves allows the Federal Reserves to adjust short term interest rates. When economy recovers, firms have more profitable opportunities to invest and banks will provide more lending options, so that economy will increase. To partially offset this growth in Reserves US Govt.-Introduced the supplementary financing program (SEP) And in case of Japanese Banks-Reserves have reduced by two thirds by raising the call rate to its level prior to the Zero interest rate policy. Bad loans have decreased by 50%.
Reserves are funds held by Banks for future transactions. Banks have to provide more and more credit to customers because cash flow in market is necessary for proper running of Economy and financial position of country.
Type of Research:
In this study we are using secondary method of data collection. Primary method can be used but it has some restrictions. In secondary Research we are collecting data from Websites, Articles and Newspaper. We are collecting data from secondary sources and after analyzing the data we are using in this project study.
Qualitative research:
It is unstructured approach. The study is classified as quality if the purpose of the study is to describe a situation, problem and information is gathered through the use of variable if analysis is done to establish variable in situation, problem without quantifying it. The extent of utilization of services is a qualitative aspect as it involves estimating the number of people who use the services.
Quantitative Research:
It is structured approach where everything that form research process-objectives, design, sample size, questions that research plan to ask to respondent is pre-determined
Scope Of Study:
Some observers have expressed concern that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover.
Meltzer (2009), for example, worries that “the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain.” Feldstein (2009) expresses similar concern that “when the economy begins to recover, these reserves can be converted into new loans and faster money growth” that will eventually prove inflationary.
Under a traditional operational framework, where the central bank influences interest rates and the level of economic activity by changing the quantity of reserves, this concern would be well justified. Now that the Federal Reserve is paying interest on reserves, however, matters are different.
When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates.
As banks lend more, new deposits will be created and the general level of economic activity will increase. Left unchecked, this growth in lending and economic activity may generate inflationary pressures. Under a traditional operating framework, where no interest is paid on reserves, the central bank must remove nearly all of the excess reserves from the banking system in order to arrest this process. Only by removing these excess reserves can the central bank limit banks’ willingness to lend to firms and households and cause short-term interest rates to rise.
Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves.
In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.
Introduction/Overview:
Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically, as shown in Figure 1.1 Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained there until the middle of September 2008.
Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented rise in excess reserves.
Why are banks holding so many excess reserves? What do the data in Figure 1 tell us about current economic conditions and about bank lending behavior? Some observers claim that the large increase in excess reserves implies that many of the policies introduced by the Federal Reserve in response to the financial crisis have been ineffective. Rather than promoting the flow of credit to firms and households, it is argued, the data shown in Figure 1 indicate that the money lent to banks and other intermediaries by the Federal Reserve since September 2008 is simply sitting idle in banks’ reserve accounts.
Edlin and Jaffee (2009), for example, identify the high level of excess reserves as either the “problem” behind the continuing credit crunch or “if not the problem, one heckuva symptom” (p.2). Commentators have asked why banks are choosing to hold so many reserves instead of lending them out, and some claim that inducing banks to lend their excess reserves is crucial for resolving the credit crisis.
This view has lead to proposals aimed at discouraging banks from holding excess reserves, such as placing a tax on excess reserves (Sumner, 2009) or setting a cap on the amount of excess reserves each bank is allowed to hold (Dasgupta, 2009). Mankiw (2009) discusses historical concerns about people hoarding money during times of financial stress and mentions proposals that were made to tax money holdings in order to encourage lending. He relates these historical episodes to the current situation by noting that “[w]ith banks now holding substantial excess reserves, [this historical] concern about cash hoarding suddenly seems very modern.”
In this edition of Current Issues, we examine how the types of policies recently implemented by the Federal Reserve, such as lending to banks and other firms, should be expected to affect the level of excess reserves.
We use a series of simple examples to illustrate the impact such policies have on the balance sheets of individual banks and on the level of reserves, both required and excess, in the banking system. The examples show that the answer to the question in our title is actually quite simple. The total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions.
The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react.
In other words, the quantity of excess reserves depicted in Figure 1 reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly. This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier. After presenting our examples, we discuss the traditional view of the money multiplier and why it does not apply in the current environment, where reserves have increased to unprecedented levels and the Federal Reserve has begun paying interest on those reserves.
We also argue that a large increase in the quantity of reserves in the banking system need not be inflationary, since the central bank can adjust short-term interest rates independently of the level of reserves and in case of Japanese Banks-
Japanese banks have chronically held excess reserves since the late ‘90s. Figure 1 illustrates the ratio of actual reserves to required reserves for commercial banks as a whole. The increasing trend in the excess reserve ratio has been conspicuous since the summer of 2001, and this ratio reached a high of 5.88 in October 2003.
The excess reserve ratio typically parallels the supply of reserves. In fact, the reserve supply began to increase when the Bank of Japan announced that it would provide ample funds to push down the uncollateralized overnight call rate, or short-term inter-bank money market rate, as low as possible, in February 1999. This action is known as the “zero-interest-rate policy.”
Furthermore, the reserve supply drastically increased after the Bank of Japan (BOJ) switched its operating target for money market operations from the uncollateralized overnight call rate to the outstanding balances of the current accounts held at the BOJ. The target level of outstanding balances of the BOJ’s current accounts was valued at around five trillion yen , but then rose to between 30 and 35 trillion yen.
However, it should be noted that the reserve supply does not necessarily automatically create a demand for reserves. The aim of this study, therefore, was to shed light on the demand side of reserves and to conduct an empirical investigation into why commercial banks hold excess reserves. In actual fact, banks have their own motives for holding excess reserves. We identified two factors that may have affected banks’ reserve demands since the late ‘90s.
The first of these factors is the nearly zero level of the call rate: the uncollateralized overnight call rate was pushed down to its minimum level after the adoption of the zero-interest-rate policy. Reserves and call loans are close substitutes; as a result, banks have more incentive to hold reserves when the call rate is very low.
The second relevant factor is the instability of the financial system. Ever since the outbreak of financial institution debacles in the late ‘90s, depositors have been very cautious about choosing which banks to deposit their money in.
This implies that, in general, once the balance sheet of a bank deteriorates, depositors will switch deposits from one bank to another, more healthy one. Therefore, banks with fragile balance sheets have an incentive to hold reserves, for precautionary reasons.2 incorporating these factors; we constructed a simple theoretical model of bank reserve demand. Using a panel dataset for banks, we estimated these banks’ optimal demand functions for reserves, as derived from the theoretical model. The quantitative importance of the aforementioned two factors was evaluated by means of a simulation analysis, based on the parameter estimates in the banks’ reserve demand functions.
Using a theoretical model, we were able to derive each bank’s optimal demand for reserves, which is a decreasing function of the short-term interest rate and an increasing function of the bank’s financial health, represented by either its bad loan ratio or the rate of change in its share price. It turned out that both factors significantly impact banks’ reserve demands, as suggested by the theoretical model. Quantitatively, the effect of the short-term interest rate on reserve demand was quite large.
We found that raising the call rate to 0.25%, its level just before the adoption of the zero-interest-rate policy, decreased the demand for excess reserves in the banking sector as a whole by as much as 55-70%. The effect of a bank’s financial health on its excess reserve demand was also significant. Excess reserves were reduced by 13-27% when the bad loan ratio was halved; this constitutes the goal to be attained by the end of FY 2004 in the Program for Financial Revival, under the Koizumi Administration.
Concept:
This study is concerned to-“Why Banks Are Holding Excess reserves.” Reserves are funds held by depositary institutions that can be used to meet the institution’s legal reserve requirement. These funds are held either as balances on deposit at the Federal Reserve or cash in the Bank vault’s or ATMs.Reserves that are applied towards an institution’s legal requirement are called required, while any additional Reserves are called excess.
Reason for existence of Fractional Reserve System
According to the United States' Federal Reserve, fractional reserve banking provides benefits to the economy and the banking system:
The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds).
Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to create money.
Thus, fractional reserve banking is a consequence of bank lending, as a bank necessarily has cash reserves that are only a fraction of deposits when it lends some of those deposits out. The fractional reserve system allows banks to act as Financial intermediaries — facilitating the movement of funds from savers to investors in society Small savers often cannot lend or invest their meager savings, for want of knowledge and sufficient capital to make a loan.
Likewise, without financial intermediaries, borrowers must seek out someone who can loan them the exact amount they need, instead of being able to draw on several loans from different small savers. Savers also face significant risk as individual investors, since if they lend to a single firm or individual, that entity can collapse, leaving the saver penniless. Furthermore, if they act as individual lenders, savers must wait for their loans to mature before recouping their money; a bank can make their deposits available at any time.
There are also significant Economy of scale in banks making investment and lending decisions, as they have access to knowledge and expertise which individual investors or lenders generally do not. Without fractional-reserve banking, a great deal of money would sit idle, as savers stored up their money, while entrepreneurs went without much-needed capital.
According to mainstream economic theory, fractional-reserve banking also benefits the economy by providing regulators with powerful tools for manipulating the money supply and interest rates, which many see as essential to a healthy economy. Moreover, the existence of fractional-reserve banking allows either the central bank or individual banks (under a free banking regime) to create money at will, allowing the supply of money to adjust to changing demand for money. A full-Reserve Banking system with a fixed money supply would result in deflation as the economy grows.
However, this deflation is likely to have deleterious consequences if some prices are stickier than others; in particular, wages are often significantly stickier than other prices. Most economists believe that given wage stickiness, the adjustment costs of deflation are significantly higher than an equivalent inflation.
As such, mainstream economic thinking prefers the inflation brought about by fractional-reserve banking to the necessary deflation of a full-reserve banking policy regime. Member banks which fall under the umbrella of the main central bank benefit from different bankruptcy regulation than a typical business. It is for this reason that the demand deposits of most banks will retain their value in spite of circumstances which would otherwise jeopardize their credit-worthiness.
How Fractional Reserve System works
The nature of modern banking is such that the cash reserves at the bank available to repay demand deposits need only be a fraction of the demand deposits owed to depositors. In most legal systems, a demand deposit at a bank (e.g. a checking or savings account) is considered a loan to the bank (instead of a bailment) repayable on demand that the bank can use to finance its investments in loans and interest bearing securities.
Banks make a profit based on the difference between the interest they charge on the loans they make, and the interest they pay to their depositors. Since a bank lends out most of the money deposited, keeping only a fraction of the total as reserves, it necessarily has less money than the account balances of its depositors.
The main reason customers deposit funds at a bank is to store savings in the form of a demand claim on the bank. Depositors still have a claim to full repayment of their funds on demand even though most of the funds have already been invested by the bank in interest bearing loans and securities. Holders of demand deposits can withdraw all of their deposits at any time. If all the depositors of a bank did so at the same time a bank run would occur, and the bank would likely collapse.
Due to the practice of central banking this is a rare event today, as central banks usually guarantee the deposits at commercial banks, and act as lender of last resort when there is a run on a bank. However, there have been some recent bank runs: the Northen Rock crisis of 2007 in the United Kingdom is an example.
The collapse of Washington mutual bank in September 2008, the largest bank failure in history, was preceded by a "silent run" on the bank, where depositors removed vast sums of money from the bank through electronic transfer. However, in these cases, the banks proved to have been insolvent at the time of the run. Thus, these bank runs merely precipitated failures that were inevitable in any case.
In the absence of crises that trigger bank runs fractional-reserve banking usually functions smoothly because at any one time relatively few depositors will make cash withdrawals simultaneously compared to the total amount on deposit, and a cash reserve can be maintained as a buffer to deal with the normal cash demands from depositors seeking withdrawals. In addition, in a normal economic environment, cash is steadily being introduced into the economy by the Central Bank and new funds are steadily being deposited into the commercial banks.
However, if a bank is experiencing a financial crisis, and net redemption demands are unusually large over a period of time, the bank will run low on cash reserves and will be forced to raise additional funds to avoid running out of reserves and defaulting on its obligations.
A bank can raise funds from additional borrowings (e.g. by borrowing from the money market or using lines of credit held with other banks), or by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of cash or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining cash reserves before they do, triggering a cascading crisis that can result in a full-scale Bank-run.
Conclusion
We began this article with a question: Why are banks holding so many excess reserves? We then used a simple example to illustrate the answer to this question in two steps. First, the Federal Reserve’s new liquidity facilities have created, as a byproduct, a large quantity of reserves and these reserves can only be held by banks.
Second, while the lending decisions and other activities of banks may result in small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter what banks do. The central message of the article is that the data in Figure 1 only reflect the size of the Federal Reserve’s policy initiatives; they say almost nothing about the effects these initiatives have had on bank lending or on the level of economic activity.
We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities.
The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis.
We empirically investigated why Japanese banks held excess reserves in the late ‘90s. We were able to pin down two factors that explain the demand for excess reserves: a low short-term interest rate, or call rate, and banks’ fragile financial health. The nearly zero call rates substantially increased the demand for reserves, and the high bad loans ratio also contributed to the observed increase in reserve holdings.
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