Question

A commercial bank has \(\$ 100\) million in checkable-deposit liabilities and \(\$ 12\) million in actual reserves. The required reserve ratio is 10 percent. How big are the bank's excess reserves? a. \(\$ 100\) million. b. \(\$ 88\) million. c. \(\$ 12\) million. d. \(\$ 2\) million.

Short answer

The bank's excess reserves are \$2 million (Option d).

Step-by-step solution

Understand the Key Terms

First, identify the terms. Actual reserves are the funds that a bank has in its vault and with the Federal Reserve. Required reserves are the minimum reserves a bank must hold, as mandated by the reserve ratio. Excess reserves are actual reserves minus required reserves.

Calculate Required Reserves

To find the required reserves, multiply the checkable deposits by the reserve ratio:\[\text{Required Reserves} = \text{Checkable Deposits} \times \text{Reserve Ratio} = 100 \text{ million} \times 0.10 = 10 \text{ million}\]

Calculate Excess Reserves

Subtract the required reserves from actual reserves to calculate excess reserves:\[\text{Excess Reserves} = \text{Actual Reserves} - \text{Required Reserves} = 12 \text{ million} - 10 \text{ million} = 2 \text{ million}\]

Select the Correct Answer

The calculated excess reserves of \\(2 million match option d. Therefore, \\)2 million is the correct answer.

Key concepts

Commercial Banks

Commercial banks are financial institutions that provide a range of services including accepting deposits, providing business loans, and offering basic investment products. They play a crucial role in economic stability by facilitating transactions and lending money to individuals and businesses.
Commercial banks accept deposits from the public, which they then lend to borrowers at a higher interest rate than they pay to depositors. This interest rate spread is one of their primary sources of income. Additionally, they offer checking and savings accounts, debit and credit cards, and sometimes brokerage and insurance services.

• They operate under strict regulations to ensure financial stability and protect depositors.
• A key regulation is the requirement to hold a certain percentage of deposits as reserves.

Understanding how they function, especially their management of reserves, is important for understanding the larger financial system.

Required Reserve Ratio

The required reserve ratio is a critical component of a bank's operations, set by a country's central banking authority. It dictates the minimum percentage of a bank's total checkable deposit liabilities that must be held in reserve at any given time.
This requirement ensures that banks retain enough liquid assets to meet short-term obligations and reduce the risk of a bank run. It acts as a safety measure for the financial system.
In this particular exercise, the required reserve ratio is 10%. This means that for every dollar deposited in the bank, the bank must keep $0.10 in reserve and can lend out or invest the remaining $0.90.

• This reserve is held in either the bank's vaults or deposited with the central bank.
• Failure to meet this ratio can result in penalties or corrective actions enforced by the central bank.

The reserve ratio can influence money supply, as changes can either tighten or loosen available funds in the economy.

Excess Reserves

Excess reserves are an additional buffer for banks over and above the required reserves. They are the surplus funds that a bank holds, which are beyond what is mandated by the required reserve ratio.
In our exercise, the commercial bank has $12 million in actual reserves but only needs $10 million according to the reserve ratio. Therefore, the bank's excess reserves are $2 million.
These reserves can be freely used by the bank for various purposes, such as:

• Lending to other clients for interest income.
• Investing in other financial products.
• Keeping additional funds to manage unexpected withdrawals or demands.

While holding excess reserves offers safety, it also represents an opportunity cost because those funds could potentially earn higher returns if invested or lent out.

Actual Reserves

Actual reserves refer to the total funds that a bank physically holds and can consist of two main components: cash in its vaults and deposits at the central bank. This total is a measure of a bank's liquidity.
For the bank in the exercise, actual reserves are $12 million. These reserves include the required reserve amount plus any excess that the bank possesses.
Having sufficient actual reserves ensures a bank’s capability to meet the demands of its depositors, particularly during unexpected surges in withdrawal requests. These reserves also provide flexibility as banks navigate day-to-day financial operations.

• Actual reserves offer insights into a bank's operational strategy and risk management practices.
• The amount in actual reserves reflects a balance between safety and profitability for the bank.

This concept is essential for evaluating the health and robustness of a financial institution in managing its obligations and expanding its lending capabilities.