Lagged Reserves

What are Lagged Reserves?

Lagged reserves are the amount of cash that a bank is required to keep in its vaults or on deposit at a Federal Reserve bank in order to meet government requirements. The term "lagged" refers to the method of calculating the reserve level for a bank, which is based on the amount on deposit two weeks prior to the date on which the reserve is set.

The reserve amount is based on the value of the bank's demand deposit accounts from the previous two weeks. The purpose of a lagged reserve is to ensure that the bank has enough money on hand to meet its anticipated expenses. Lagged reserves are also called fractional reserves.

The Federal Reserve set the rate of reserves at zero percent in March 2020, effectively eliminating the requirement for now.

Understanding Lagged Reserves

No bank keeps enough cash on hand to meet the demands of all of its customers if they all demanded to withdraw their savings all at once. Banks make money by using their customers' cash for new loans and other investments that will pay them more than they pay their customers in interest on their deposits.

In fact, most of the dollars circulating in our modern economy never appear in the bank in paper form. They exist as accounting entries in a bank office that are then transferred to other accounts as the money is lent out.

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

The requirement for fractional reserves is a way of making sure that the banks have a reasonable amount of cash on hand if there is an unanticipated level of demand.

Minimum reserve requirements are set by the Fed's board of governors as one of its monetary policy tools. As of March 2020, the Fed has set minimum reserves for banks at zero percent.

In order to verify that banks have sufficient reserves to meet minimum requirements, the Fed needs some rule to calculate the total size of a bank’s deposits. These deposits fluctuate significantly day-to-day or even over the course of a single business day. The system of lagged reserves requires a bank's currency reserves held with the Federal Reserve to be tied to the value of its demand deposit (that is, checking) accounts from two weeks earlier.

For example, if a bank's demand deposits were $500 million on a given date, and its reserve requirement was 10%, its currency reserves two weeks later would need to equal $50 million. This two-week lag gives banks plenty of time to ensure they have the necessary reserves (on a given day) to cover minimum reserve requirements for deposits (two weeks prior).  

History of Lagged Reserves

Prior to 1968, the Federal Reserve required banks to calculate necessary reserves each week based on their deposits in that same week. 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 of 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 COVID-19 outbreak and ensuing lockdowns.

The Bottom Line

Lagged reserves are set by the Federal Reserve, and they are both a form of insurance and a monetary policy tool.

The insurance aspect relates to the requirement that each bank must keep enough cash on hand to deal with the needs of their customers. Whether that is enough to stave off a full-out run on the bank is questionable. It didn't work for Silicon Valley Bank in March 2023.

In any case, the current minimum lagged reserves level for all banks is set at 0%, indicating that the Federal Reserve wants to keep the economy healthy by ensuring that banks have plenty of money to lend out. That is the second aspect of lagged reserves: The level of reserves is raised or lowered by the Fed to slow down or jump-start economic activity.