A commercial bank has provided the following financial information. Assume that the Federal Reserve has reinstituted reserve requirements.
Average daily net transaction accounts balance during the reserve computation period: $2,945.00M
Average daily reserves held with the Federal Reserve during the reserve maintenance period: 204.56M
Average daily vault cash during the reserve maintenance period: 87.54M
a. Calculate the bank’s target reserve using the requirement prior January 2020.
b. Calculate the amount of reserves that bank must maintain with the Federal Reserve vault cash does not change during the maintenance period based on the requirement prior to January 2020.
c. Is the bank undershooting or overshooting the reserve target? Support your response.
The correct answer and explanation is :
Solution:
Reserve Requirement Prior to January 2020:
The Federal Reserve’s reserve requirement structure before January 2020 was as follows:
- 0% on the first $16.9 million of net transaction accounts.
- 3% on amounts above $16.9 million up to $127.5 million.
- 10% on amounts above $127.5 million.
Step 1: Calculate the Bank’s Target Reserve
The bank’s average daily net transaction accounts balance = $2,945.00M
Now, applying the reserve requirement:
- First $16.9M at 0%:
[
16.9M \times 0\% = 0M
] - Next ($127.5M – $16.9M = $110.6M) at 3%:
[
110.6M \times 3\% = 3.318M
] - Remaining ($2,945.00M – $127.5M = $2,817.5M) at 10%:
[
2,817.5M \times 10\% = 281.75M
]
Total Required Reserve (Target Reserve):
[
0M + 3.318M + 281.75M = 285.068M
]
Step 2: Calculate Required Reserves with the Fed
The bank can use vault cash to meet part of the reserve requirement.
Given:
- Vault cash = $87.54M
- Total reserve requirement = $285.068M
The required reserves to be held with the Federal Reserve:
[
285.068M – 87.54M = 197.528M
]
Step 3: Determine if the Bank is Undershooting or Overshooting the Target
The bank’s actual reserves held with the Fed = $204.56M
Required reserves with the Fed = $197.528M
[
204.56M – 197.528M = 7.032M \quad (\text{excess reserves})
]
The bank is overshooting the required reserves by $7.032M.
Explanation (300 Words):
The Federal Reserve enforces reserve requirements to ensure banks maintain sufficient liquidity to meet withdrawal demands. Before January 2020, reserves were determined using a tiered structure, where transaction balances up to $16.9M were exempt, balances between $16.9M and $127.5M required 3%, and amounts exceeding $127.5M required 10%.
Given the bank’s net transaction accounts of $2,945.00M, applying these rates results in a total reserve requirement of $285.068M. Banks can use vault cash to meet part of this requirement. Since the bank has $87.54M in vault cash, it must hold the remaining $197.528M in its Federal Reserve account.
The bank’s actual reserves with the Fed total $204.56M, which exceeds the required reserve by $7.032M. This indicates that the bank is overshooting its reserve requirement, holding more reserves than necessary.
Excess reserves can indicate a cautious approach by the bank, ensuring it has sufficient liquidity to cover potential withdrawal demands or meet internal risk management objectives. However, holding excess reserves may reduce profitability because reserves held at the Fed typically earn lower interest compared to other lending or investment opportunities. Banks often try to minimize excess reserves while ensuring compliance with regulations.
In conclusion, the bank is holding more reserves than required by approximately $7.032M. While this provides additional liquidity, it may limit the bank’s ability to generate higher returns through lending or investments. The bank could consider deploying some of these excess reserves into higher-yielding assets while still ensuring regulatory compliance.