A:

In economics, required reserves play an important role in ensuring the stability of banks and how a central bank conducts its monetary policy. Reserve requirements represent an amount of funds that a central bank requires banks to hold in reserve against deposit liabilities. Bank reserves are typically calculated based on the reserve ratio, which is a percent of deposits, and must be held as vault cash or deposits with a central bank. Reserve requirements affect banks and their shareholders by making depositary institutions more stable and less susceptible to sudden bank runs in case of a large and unexpected need for liquidity. However, bank reserves present an opportunity cost to banks and their shareholders, as financial institutions forgo profits that could be earned on the required reserves.

Bank Reserves

The amount of required reserves is determined based on the reserve ratio specified by a central bank. In the United States, the Federal Reserve Board's Regulation D specifies the reservable liabilities, which are net transaction accounts such as checking and savings accounts and various transfer accounts. Since January 2015, net transaction accounts with a value less than $14.5 million require zero required reserves, while accounts with a value in excess of $14.5 million but less than $103.6 million require 3% required reserves. All net transaction accounts with a value more than $103.6 million must have 10% required reserves.

Effect on Banks' Shareholders

The required reserve system was established to enhance stability of financial institutions in case of sudden runs on banks. However, this tool had limited success in preventing bank panics. Instead, the United States uses reserve requirements as a tool in its monetary policy.

Reserve requirements also impose opportunity costs on banks and their shareholders in the form of forgone income that banks could have earned on other investment projects. The opportunity costs grow significantly as the level of reserve requirements increases for large deposit liabilities. As a mitigating factor, since 2008, the United States pays interest on bank reserves to compensate banks for implicit tax imposed on them.

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