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There are two different types of requirements that banks have to maintain: capital requirements and reserve requirements. They are very different things, and r

There are two different types of requirements that banks have to maintain: capital requirements and reserve requirements. They are very different things, and reserve requirements aren't the important or binding one. Capital requirements mandate how many assets banks must have relative to their liabilities. If a bank has $100,000 in deposits(=liabilities), their capital requirements mean they must have around $105,000 in assets (bonds, mortgages, etc.). There are also additional requirements about how much must be held in cash equivalents(T-bills, etc.). If a bank becomes too leveraged, or its assets decline sufficiently in value, then the FDIC takes the bank over. Reserve requirements relate to how much of one kind of asset banks must have relative to their liabilities -- "bank reserves". "Bank reserves" are a special kind of currency issued by the Fed that only are used for accounting between the Fed and banks. Banks that are short of reserves overnight(say, because they got a bunch of deposits that day), must borrow them from other banks that have too many to maintain their reserve requirements. Like Bernanke said, this overnight borrowing was a major issue during the crisis. Since any bank that was borrowing was at risk for going bankrupt overnight, there was immense counterparty risk generated by what was supposed to be payment clearing mechanism. The Fed wants to move towards having banks borrow from them overnight, instead of from other banks. http://en.wikipedia.org/wiki/Federal_funds http://en.wikipedia.org/wiki/Federal_funds , http://en.wikipedia.org/wiki/Bank_reserves http://en.wikipedia.org/wiki/Bank_reserves , http://en.wikipedia.org/wiki/Excess_reserves http://en.wikipedia.org/wiki/Excess_reserves , and http://www.winterspeak.com/2009/12/banks-are-even-more-super-than-i.html http://www.winterspeak.com/2009/12/banks-are-even-more-super... may be informative.

anigbrowl 17y ago
Excellent summation. Thank you for the free macroeconomics lesson.
Retric 17y ago
They are both important but they do different things. Reserve requirements is how you avoid infinite inflation.
- dfranke 17y ago
  Right, you beat me to it. Captial requirements are there to prevent banks from going insolvent. Reserve requirements are there to prevent the money supply from spiraling out of control. These are completely different objectives.
  - jplewicke 17y ago
    Thanks for pointing this out. Our problem now is that even with reserve requirements, banks can use securitization to expand the money supply infinitely: http://arxiv.org/abs/0904.1426 http://arxiv.org/abs/0904.1426 . Reserve requirement aren't normally the binding constraints on banks, but they might have helped prevent some pathological situations in the past. The rise of shadow banking has shown that they are no longer a sufficient constraint.
- bokonist 17y ago
  As I understand it, the Fed would control the amount of inflation by setting the interest rates directly. Essentially, banks would be able to create money when they are able to find a lending opportunity that will pay a greater amount of interest than the federal funds rate. By raising or lowering the rate, the Fed can control the amount of inflation. This is at least my understanding of how it would work, I'm not an expert in banking, but you can follow sites like this one http://reservedplace.blogspot.com/2009/04/easing-understanding.html http://reservedplace.blogspot.com/2009/04/easing-understandi... or winterspeak.com to learn more.
  - anamax 17y ago
    > As I understand it, the Fed would control the amount of inflation by setting the interest rates directly. Except that you can't control the amount of inflation by setting "the" interest rate. You can try to affect inflation with interest rates, but you can't control it. Inflation is too much currency chasing too few goods. Interest rates paid by banks aren't the only currency supply drivers. Velocity matters, and so does govt spending, among other things.
hristov 17y ago
This is a very misleading explanation. Reserve requirements are how much cash (or equivalents) the banks must hold in comparison to certain types of liabilities. The liabilities are usually customer deposits, or other liabilities that can be called on a moment notice. See: http://en.wikipedia.org/wiki/Reserve_requirement http://en.wikipedia.org/wiki/Reserve_requirement This is not just some arcane rule, it is actually a very important requirement that prevents bank failures. That is it prevents a bank from running out of cash to pay its depositors. If a bank runs out of cash, even for a short time and even if it has large amount of long term illiquid assets, the bank will probably fail as people will panic, there will be a run on the bank, etc. It is true that banks usually use something called federal funds to satisfy the reserve requirement. Federal funds are money held on account at the federal reserve. Thus, each banks has an account at the Fed, that has money in it, and that money is called the federal funds. The federal funds are considered to be the equivalent of cash for the reserve requirement, so most banks satisfy the reserve requirement using their federal funds (as holding large amounts of cash in their vaults is expensive and inconvenient). Nevertheless, the reserve requirement is not some unimportant technical rule that emerged from the Fed lending system as your post suggests, but an important requirement needed to ensure banks stay solvent and are actually able to give your money when you go to an ATM machine.

anigbrowl 17y ago

Excellent summation. Thank you for the free macroeconomics lesson.

Retric 17y ago

They are both important but they do different things. Reserve requirements is how you avoid infinite inflation.

dfranke 17y ago
Right, you beat me to it. Captial requirements are there to prevent banks from going insolvent. Reserve requirements are there to prevent the money supply from spiraling out of control. These are completely different objectives.
- jplewicke 17y ago
  Thanks for pointing this out. Our problem now is that even with reserve requirements, banks can use securitization to expand the money supply infinitely: http://arxiv.org/abs/0904.1426 http://arxiv.org/abs/0904.1426 . Reserve requirement aren't normally the binding constraints on banks, but they might have helped prevent some pathological situations in the past. The rise of shadow banking has shown that they are no longer a sufficient constraint.
bokonist 17y ago
As I understand it, the Fed would control the amount of inflation by setting the interest rates directly. Essentially, banks would be able to create money when they are able to find a lending opportunity that will pay a greater amount of interest than the federal funds rate. By raising or lowering the rate, the Fed can control the amount of inflation. This is at least my understanding of how it would work, I'm not an expert in banking, but you can follow sites like this one http://reservedplace.blogspot.com/2009/04/easing-understanding.html http://reservedplace.blogspot.com/2009/04/easing-understandi... or winterspeak.com to learn more.
- anamax 17y ago
  > As I understand it, the Fed would control the amount of inflation by setting the interest rates directly. Except that you can't control the amount of inflation by setting "the" interest rate. You can try to affect inflation with interest rates, but you can't control it. Inflation is too much currency chasing too few goods. Interest rates paid by banks aren't the only currency supply drivers. Velocity matters, and so does govt spending, among other things.

hristov 17y ago

This is a very misleading explanation. Reserve requirements are how much cash (or equivalents) the banks must hold in comparison to certain types of liabilities. The liabilities are usually customer deposits, or other liabilities that can be called on a moment notice. See: http://en.wikipedia.org/wiki/Reserve_requirement http://en.wikipedia.org/wiki/Reserve_requirement This is not just some arcane rule, it is actually a very important requirement that prevents bank failures. That is it prevents a bank from running out of cash to pay its depositors. If a bank runs out of cash, even for a short time and even if it has large amount of long term illiquid assets, the bank will probably fail as people will panic, there will be a run on the bank, etc. It is true that banks usually use something called federal funds to satisfy the reserve requirement. Federal funds are money held on account at the federal reserve. Thus, each banks has an account at the Fed, that has money in it, and that money is called the federal funds. The federal funds are considered to be the equivalent of cash for the reserve requirement, so most banks satisfy the reserve requirement using their federal funds (as holding large amounts of cash in their vaults is expensive and inconvenient). Nevertheless, the reserve requirement is not some unimportant technical rule that emerged from the Fed lending system as your post suggests, but an important requirement needed to ensure banks stay solvent and are actually able to give your money when you go to an ATM machine.