How can banks hold only $0 now in deposits?! Can someone break this down



In: Economics

The “Reserves Requirement” set by the Fed is just setting the amount of money that the bank needs to store at the Fed – not the amount of cash that it need to maintain at its own banks to be considered solvent.

Federal Law requires interstate banks in the US to deposit a percentage of their total deposits with the Fed, which the Fed gets to set.

There’s nothing necessary about banks storing their money with the Fed. The reason that this was done was because there was a lot of opposition to the formation of a Federal Central Bank when in the 1930’s when the Fed was created. To help get Congress to agree to create the Fed, it was structured in a rather bizarre way to make it look like it wasn’t really a central bank (even though it was). The reserve requirement was part of this structure as it made the Fed appear to just be a normal bank (even though its not).

The Fed has been slowly moving away from that model for the past 20 years by slowly reducing the reserve requirement. It would have gotten there eventually, but used the current Coronavirus crisis as an excuse to fast track the 0% requirement.

This does not mean that banks can hold $0 in deposits. The ratio of cash on hand to deposits that banks need to maintain is controlled by the Fed’s Capital Requirements. The Fed’s Capital Requirements are incredibly complex but haven’t changed much in decades and have a minimum of 4% (though they are frequently higher).

All of the above is only true in the US. The terms “Reserve Requirements” and “Capital Requirements” can and do mean completely different things in other countries.

The reserve requirement ratio determines the minimum amount of reserves banks have to hold relative to their deposits. Banks will still hold reserves even if there is no requirement to do so. Canada for example has not had a reserve requirement since 1992.

A common misconception is that banks need deposits first before they can lend out money. What banks actually do is they create a new deposit when they lend money. The money is not taken from somewhere, it is created when the loan is made. A deposit is just the amount of money the bank owe the deposit owner. If you borrow 1 million dollars from a bank, you owe the bank 1 million dollars that has to be paid back in x number of years with interest. In return, the bank now owe you 1 million dollars.

Reserves should not be confused with the deposits that banks have. Reserves is a type of money issued by the central bank, and is located on the asset side of bank balance sheets. Banks hold reserves in their account at the central bank. Only banks can own central bank reserves, and they are used to settle transactions between banks. Banks need to settle transactions between each other every day. Let’s say that you buy something at a store with a debit card. If the store is not using the same bank as you, your bank needs to transfer money to the bank used by the store to settle the transaction.

Now banks do not do this for every transaction that happens between banks. Instead they calculate the necessary net transfers they need to make to other banks, but the point remains the same. This is what reserves are used for. Sometimes banks do not have enough reserves to settle their transactions. In that case they will typically borrow money from other banks, or in certain cases from the central bank.

The amount of deposits is not necessarily related to the amount of reserves a bank has. Although as explained above, if enough depositors decides to transfer their deposits to other banks, the bank will need to either have or obtain enough reserves to settle the transactions.