Contemporaneous Reserves

What Are Contemporaneous Reserves?

Contemporaneous reserves are a form of bank reserve accounting that requires a bank to maintain enough reserves to cover all deposits made during a week. The use of contemporaneous reserves accounting was designed to reduce short-term monetary fluctuations.

Prior to using contemporaneous reserves, the Fed instead used a system of lagged reserves. The Federal Reserve mandated banks to use contemporaneous reserve accounting between 1984 and 1998, after which time the Fed's mandate switched back to lagged reserves accounting.

Understanding Contemporaneous Reserves

Reserves represent the amount of cash that banks must keep as paper notes in their vaults or on account at the closest Federal Reserve bank to back deposits made by their customers. Because banks operate on a system of fractional reserves, no bank keeps enough cash on hand to cover deposits should all of a bank's customers withdraw their money at the same time.

This is because most money never exists in physical form as Federal Reserve notes. Instead, money is created as accounting entries in a bank's accounts when it is lent to borrowers and then circulated through the economy.

Banks need to hold enough physical cash (or liquid deposits of their own at the Fed) to pay their immediate liabilities, including customer deposit account withdrawals and payments on other debts. Otherwise, banks risk defaulting on their liabilities to other banks or being shut down by the Federal Deposit Insurance Company (FDIC) in the event of a bank run.

Contemporaneous reserves are difficult for banks to calculate because they cannot be sure of the amount of money they will receive throughout the week from deposits. This forces banks to estimate the amount deposited, which creates the risk of forecasting incorrectly.

Despite enacting the contemporaneous reserves requirement, banks were still running into trouble making estimates, and money supply indicators such as M1 and M2 kept fluctuating.

Contemporaneous vs. Lagged Reserves

Lagged reserves is a method to calculate the required level of bank reserves kept on hand or with a Federal Reserve bank. The required reserve amount is based on the value of the bank's demand deposit accounts from the previous two weeks, rather than the expected deposits made in a one-week window as contemporaneous reserves require. This makes lagged reserves a more conservative measure.

The creation of the contemporaneous reserves requirement was in response to pressures on the money supply, which some economists believed was caused by the lagged reserve accounting method that banks were using at the time.

The lagged reserve requirements allowed banks to estimate reserves based on deposits from two weeks prior. Economists speculated that banks were creating deposits and loans with insufficient funding and that banks felt confident making these moves because they knew the Federal Reserve would lend money at the discount window if they got into trouble.

Prior to 1968, the Federal Reserve required banks to calculate necessary reserves each week based on their deposits in that same week. The lagged reserve calculation was used from 1968 until 1984 when contemporaneous calculations were re-implemented. But the Fed reverted to the lagged calculation in 1998, in order to make it easier for banks to estimate and plan the amount of reserves they would need to hold.

In March 2020, the Fed dropped all required reserve ratios to zero, rendering moot the need to calculate minimum required reserves. The move was a part of accommodative monetary policy measures in response to the economic impact of the 2020 crisis and ensuing lockdowns.

The Bottom Line

Contemporaneous reserves were introduced to reduce short-term monetary fluctuations due to deposit withdrawals. It is a bank reserve accounting measure that requires banks to maintain enough reserves to cover all deposits made to their institution during a week. In March 2020, the Fed dropped all required reserve ratios to zero.