GLOBAL The Worldwide Decline in Reserve Requirements In order to meet the demand for withdrawals by depositors or to pay the cheques drawn on depositors accounts, depository institutions need to keep...

GLOBAL The Worldwide Decline in Reserve Requirements

In order to meet the demand for withdrawals by depositors or to pay the cheques drawn on depositors accounts, depository institutions  need to keep sufficient reserves on hand. In most countries, banks hold a certain amount of non interest-bearing reserves because of  legally imposed reserve requirements. These reserves are called required reserves. The rationale for reserve requirements is that  reserves are necessary for monetary control  purposes and, to a lesser extent, for the protection  of depositors and the stability of the banking system. In recent years, however, central banks in many countries in the world have been reducing or eliminating their reserve requirements. In the euro area the required reserve ratio is 2% of bank deposits, while in the United States it  is 3% (rising to 10% for large deposits). Canada has gone a step further: financial market legislation in June 1992 eliminated all reserve requirements over a two-year period. The central  banks of Switzerland, New Zealand, and Australia have also eliminated reserve requirements entirely. What explains the downward trend in reserve requirements in most countries? You may recall from Chapter 11 that  reserve requirements act as a tax on banks. Because central banks typically do not pay  interest on reserves, the bank earns nothing on them and loses the interest that could have been earned if the bank held loans  instead. The cost imposed on banks from reserve requirements means that banks, in  effect, have a higher cost of funds than other deposit-based financial institutions not subject to reserve requirements, making them less competitive. Central banks have thus been reducing reserve requirements to make banks  more competitive and stronger. Although central banks have been reducing or eliminating their reserve requirements,  banks still want to hold reserves to protect  themselves against predictable and unpredictable cash and clearing drains. Hence, desired reserves is the appropriate term to  describe the reserves of deposit-taking financial institutions in a system without reserve requirements.