THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 439

CHAPTER 16 GLOBAL The Money Supply Process 407 The Worldwide Decline in Reserve Requirements In order to meet the demand for withdrawals by depositors or to pay the cheques drawn on depositors accounts, depository institutions need to keep sufficient reserves on hand In most countries, banks hold a certain amount of non interest-bearing reserves because of legally imposed reserve requirements These reserves are called required reserves The rationale for reserve requirements is that reserves are necessary for monetary control purposes and, to a lesser extent, for the protection of depositors and the stability of the banking system In recent years, however, central banks in many countries in the world have been reducing or eliminating their reserve requirements In the euro area the required reserve ratio is 2% of bank deposits, while in the United States it is 3% (rising to 10% for large deposits) Canada has gone a step further: financial market legislation in June 1992 eliminated all reserve requirements over a two-year period The central banks of Switzerland, New Zealand, and Australia have also eliminated reserve requirements entirely What explains the downward trend in reserve requirements in most countries? You may recall from Chapter 11 that reserve requirements act as a tax on banks Because central banks typically not pay interest on reserves, the bank earns nothing on them and loses the interest that could have been earned if the bank held loans instead The cost imposed on banks from reserve requirements means that banks, in effect, have a higher cost of funds than other deposit-based financial institutions not subject to reserve requirements, making them less competitive Central banks have thus been reducing reserve requirements to make banks more competitive and stronger Although central banks have been reducing or eliminating their reserve requirements, banks still want to hold reserves to protect themselves against predictable and unpredictable cash and clearing drains Hence, desired reserves is the appropriate term to describe the reserves of deposit-taking financial institutions in a system without reserve requirements Bank s purchase and sale of these securities) Government securities are by far the Bank s largest category of assets, accounting for over 80% of the balance sheet Advances The second way the Bank of Canada can provide reserves to the banking system is by making advances (loans) to banks For the banks, the Bank of Canada advances they have taken out are referred to as borrowing from the Bank of Canada or, alternatively, as borrowed reserves There is a big difference between normal advances and extraordinary advances (to be discussed in detail later) lent by the Bank of Canada to troubled banks to prevent bank and financial panics Normal advances are fully collateralized and generally overnight in duration The interest rate charged banks for these loans is called the bank rate