DEFINITION of Primary Reserves
Primary reserves are the minimum amount of cash required to operate a bank. Primary reserves also include the legal reserves that are housed in a Federal Reserve or other correspondent bank. Checks that have not been collected are included in this amount as well.
BREAKING DOWN Primary Reserves
Primary reserves are kept in order to cover unexpected major withdrawals or runs of withdrawals. They serve as a defense against a substantial reduction in liquidity. These reserves must be kept more liquid than secondary reserves, which may be invested in marketable securities such as Treasury offerings.
Primary Reserves Example
This is how primary reserves work at a commercial bank, assuming a 20% reserve requirement. A depositor puts $500 in Bank A. The bank keeps $100 of it to meet its primary reserve requirement, then lends the rest ($400) to another customer, who uses that money to purchase groceries. The grocery store in turn deposits that $400 in Bank B account. Now, Bank B is required to keep $80 (20%) of that amount on reserve, then lends the other $320 as its own excess reserves. When that money is lent out, it in turn goes on deposit at a third institution, and the cycle continues.
In this example, that original $500 becomes $1,220 on deposits in three different institutions, which is known as a multiplier effect. The size of the multiplier can be adjusted depending on the amount of money banks must keep on reserve. When the Federal Reserve requires banks to increase or decrease reserves, the multiplier changes, which can either pump money into or drain money out of the economy. This is known as contracting or expanding the money supply.
Banks can raise or lower their own reserves within the federal limits, depending on whether they need more or less cash. If many banks raise more cash at the same time to meet a financial crisis, this can shrink the money supply and can have repercussions across the economy, creating a credit crunch.
A credit crunch is an economic condition in which investment capital is hard to secure. Individuals and businesses that could formerly obtain loans to finance major purchases or expand operations suddenly find themselves unable to acquire such funds. Banks and investors become wary of lending funds to individuals and corporations, which drives up the price of debt products for borrowers. Often an extension of a recession, a credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, resulting in higher rates.