Banks have a way of being their own worst enemy. It doesn’t help that they are encouraged by lenient guardrails where it matters the most, not least being the reserve requirement ratio.
It’s an eye-opener for consumers to learn that banks don’t match their savings account deposits dollar-for-dollar (euro for euro, etc.) in a vault. As the reality of this alarming reality spreads, the risks of leaving one’s money in a bank become clearer.
In this article, we’ll explore the reserve ratio and how it is playing into the failures that have plagued the banking industry, particularly in the United States, as well as what it all means for consumer deposits.
The reserve requirement ratio represents the percentage of customer deposits that banks must keep in vault cash, aka currency on hand, or at the Fed. They can’t lend it, invest it or do anything else with it to meet this standard.
Central bankers can and do manipulate the reserve requirement ratio to increase the money supply circulating in the economy.
The reserve ratio, which could also be called the cash reserve ratio, is set by a country’s central bank, like the Federal Reserve in the United States.
As an example of how this works, let’s say that the reserve requirement ratio is 10%, and a customer makes a deposit for $1,000. The bank must earmark $100 at the end of the day for reserves. If the bank comes up short for that amount, it can go knock on the door of other banks to borrow federal funds or use the Fed’s discount window.
What does this bank do with the other $900? Lend it to customers in the form of mortgage loans, personal loans, small business loans, etc. The banks earn more from interest on those loans than it would leaving it sitting idle in the vault. You can pretty much guarantee that the bank is generating higher interest from those loans than customers would by socking away their cash in a savings account.
Once again , the bank reserves must be in the vault each day at the close of business or in the nearby Federal Reserve bank. This is to ensure that there are theoretically sufficient reserves so the bank won’t buckle under the pressure of a potential run. This rule applies to -
The weaker the reserve requirement ratio, the greater the chance of a run on a bank, as evidenced by the fallout at Silicon Valley Bank. The higher the reserve requirement, the tougher it is for small and medium-sized banks to compete with loans because they have to keep more of their deposits in reserves.
In the United States, the reserve requirement ratio for banks is zero percent, a threshold that was set by the Federal Reserve board of governors in the wake of the health crisis. More about that later.
Reserve requirements date back to the 1860s when the National Bank Act came into effect. While the rule has evolved from its early beginnings, the idea is similar: to ensure to the extent possible banks keep a fraction of their deposits in a safe place. It’s much different from stablecoins, the leading ones of which maintain reserves of 1:1 to the pegged asset. But we digress.
Even before the Fed was formed in 1913, it was clear that some reserve parameters needed to be set to protect banks from themselves when the financial system is pushed to the brink. However, reserve requirements failed to do their job as the keeper of liquidity as panic-filled bank runs happened anyway.
With the emergence of the Fed, reserve requirements took a sharp turn. Central bankers wield a great deal of power, including the ability to print money. Therefore, reserve requirements became less vital to the banking system and all of its participants. These days, policymakers use reserve requirements more like a weapon in their arsenal when implementing changes to monetary policy.
Below is a list of some of the major economies and their corresponding reserve requirement ratio for banks:
The U.S. reserve requirement is currently zero on non-transactional accounts. It’s been hovering at that level since mid-March 2020. The catalyst for this severe cut was the COVID-19 pandemic, in response to which the Fed wanted to encourage banks to lend to one another.
This “requirement” paves the way for banks to hold zero reserves for bank deposits in the vault. It exacerbates the issues inherent with fractional reserve banking to begin with. With the recent failure of SVB and a handful of other banks, the writing is on the wall in terms of the risks associated with a zero reserve requirement.
Prior to the latest cut, the reserve requirements weren’t much better —
The U.S. is far from the only country that is targeting a low reserve requirement. In Q1 2023, China slashed its reserve requirement ratio by 25 basis points, unlocking tens of billions of dollars. The PBOC was looking to jumpstart an economic recovery in the country that had stalled.
Next time you make a deposit at your local bank, you might want to think twice about it. The risks of fractional reserves have never been greater, based on the recent failures in the banking system.
While central bankers are never more than a stone’s throw away, that only increases the likelihood they will turn on the money machines to keep the economy afloat until they can’t keep up the charade any longer.
Banks have always gotten away with it because for a long time there haven’t been any alternatives, except for gold. The rise of cryptocurrencies has changed that, giving people more choices to secure their funds.
Protocols like Liquid Loans are truly over-collateralized. This takes the risk of a bank run all the way to zero percent.
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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.
Gerelyn is a financial journalist who has been covering Wall Street for more than 20 years. After reporting for some of the top trade publications on investment banking, infrastructure and retirement, she was drawn to decentralization and shifted her coverage to the blockchain and cryptocurrency space in mid-2017. Since then, she has contributed to several major Bitcoin, Blockchain, and DeFi news sites, and has also written a children’s book.
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