Question

Explain what would happen if banks were notified they had to increase their required reserves by one percentage point from, say, \(9 \%\) to \(10 \%\) of deposits. What would their options be to come up with the cash?

Short answer

In response to the increase in required reserves from 9% to 10% of deposits, banks have the following options: (1) reduce lending, which may hurt their profitability; (2) raise funds from the market by issuing securities or borrowing, which may be more expensive than internal funding; (3) sell assets, although this may affect their long-term financial position; or (4) seek central bank support, which may signal financial weakness. Banks must carefully evaluate their situation and choose the best option to achieve the additional cash equal to 0.01 times their total deposits.

Step-by-step solution

Understand the reserve requirement concept

The reserve requirement is the minimum amount of cash banks are required to hold against customer deposits as a percentage, as determined by the central bank. This requirement is in place to ensure that banks have enough liquidity to cover potential withdrawals by customers. In this exercise, banks are required to increase their reserves from 9% to 10% of deposits.

Calculate the change in required reserves

Given the 1 percentage point increase in the reserve requirement, banks now need to hold additional cash equal to 1% of their total deposits. If the total deposits are denoted as \(D\), then the change in required reserves is equal to \((10\% - 9\%)*D \Rightarrow 0.01D\). In other words, banks now need to come up with additional cash equal to 0.01 times their total deposits.

Option 1: Reduce lending

One option for banks to come up with the additional cash required is to reduce their lending activities. By doing so, banks can decrease their loan portfolio's size, freeing up some of the cash that can then be used to meet the increased reserve requirement. However, this option might not be favorable for banks, as it could potentially hurt their profitability and overall business model.

Option 2: Raise funds from the market

Another option for banks to come up with the additional cash is to raise funds from the market, either by issuing new securities, such as bonds or shares, or borrowing from other banks in the interbank market. This option enables banks to have access to external funds that can be used to meet the increased reserve requirement. However, raising funds from the market might be more expensive than internal sources of funding, depending on market conditions.

Option 3: Sell assets

Banks can also consider selling assets, such as loan portfolios, securities, or other investments, to raise the additional cash needed for the increased reserve requirement. This might be a viable option if the bank holds assets that are easy to sell and can generate a reasonable amount of cash. However, banks must carefully consider the consequences of selling particular assets, as disposing of them may affect their long-term financial position.

Option 4: Seek central bank support

In some cases, banks may be unable to come up with the additional cash through other options, forcing them to seek support from the central bank. Central banks can provide financial assistance through various tools, such as emergency lending measures or temporary reduction in the reserve requirement. However, relying on central bank support may signal a bank's financial weakness, affecting its reputation and market value. In conclusion, banks have several options to come up with the additional cash required for the increased reserve requirement, such as reducing lending activities, raising funds from the market, selling assets, or seeking central bank support. Each option has its pros and cons, and banks must carefully evaluate their situation to determine the best course of action.