What Are Primary Reserves?
Primary reserves are the minimum amount of cash legally required to operate a bank. Primary reserves also include the legal reserves housed in a Federal Reserve bank or other correspondent bank. Checks that have not been collected are included in this amount as well.
The legal primary reserve requirement may or may not be the binding constraint on banks' ability to expand the supply of credit in the economy. Market conditions may dictate that banks simply need to keep more liquidity on hand to avoid defaults.
- Primary reserves are the minimum legal amount of reserves that a bank is required to hold against its deposits.
- The amount of reserves that banks hold helps determine the total supply of money and credit in the economy.
- In the United States, the Federal Reserve sets the reserve requirement as one of its monetary policy tools, lowering the requirement to expand the money supply or raising it to contract the money supply.
- As of March 2020, the Fed has lowered all reserve requirements to zero, but banks continue to hold reserves based on their own liquidity needs rather than a legal constraint.
Understanding Primary Reserves
When a customer deposits money with a bank, the bank is required to keep a certain fraction held in reserve. A portion of deposits are held in reserve as liquid funds, while the rest is lent to borrowers or invested in less liquid assets.
Primary reserves are kept to cover normal day-to-day withdrawals and especially 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 represent the base of the pyramid of credit that makes up the overall supply of money in the economy through the practice of fractional reserve banking. The vast majority of money in the economy consists of electronic or other accounting entries created out of thin air by the banks when they lend out the deposits they also hold on account on behalf of the depositors. The Federal Reserve, acting in its capacity as a regulator of the banking system, requires banks to keep some small percent of customer deposits on hand as liquid funds to pay out withdrawals, and banks are only allowed to lend out a fraction of the deposits they receive. This acts a brake on banks' ability to simply create an infinite amount of new money, as well as an opportunity cost for the banks to hold deposits as cash with little or no return for the bank.
By increasing or decreasing the amount of primary reserves that banks are required to hold, the Federal Reserve can tighten or loosen credit conditions and the available supply of money and credit in the economy. Banks can also 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 the demands of their depositors and other creditors by selling off assets or liquidating loans, this can shrink the money supply and can have repercussions across the economy, creating a credit crunch. On the other hand, if the banks all lower their reserves they can quickly expand the volume of credit available in the economy, but at the risk of triggering credit bubbles and ultimately inflation or even a recession once the bubbles burst.
However, as of March 2020 the Federal Reserve eliminated reserve requirements for all depository institutions in order to free up liquidity for banks to increase lending to businesses and households. For now, the Fed does not have plans to re-impose reserve requirements in the future.
In effect, banks now only need to hold whatever cash reserves they believe they need to cover their customer withdrawals and other liquidity needs and are not required by the Fed to hold any cash if they choose not to. The only constraint on banks in this case is the risk that holding inadequate reserves might lead to bank bankruptcies or defaults if they do not hold sufficient cash to pay their depositors and other creditors.
Since the 2007-08 Financial Crisis, this market constraint has been the binding reserve requirement for banks anyway. Since 2008, banks have held trillions of dollars in combined excess reserves above and beyond the Fed's reserve requirement.