When you deposit money into a checking or savings account, you can safely assume that your money will be available to you whenever you’d like to use it. Banks wouldn’t be profitable (and therefore wouldn’t exist) if all they provided was a building in which to store your cash, so they’re allowed to use your deposits to provide loans and make investments. The Federal Reserve requires banks to keep a percentage of its customers’ deposits on hand, otherwise banks might spend all of your money however they liked and you couldn’t be certain you’d see it again. This percentage is called the required reserve ratio, or reserve requirement, and it’s determined by the Fed as a tool of monetary policy.
A Brief History of Fractional Reserve Banking
Almost every state in the world with a banking system uses fractional reserve banking as a tool of regulation. In the early 19th century, before the US used a national currency, banks maintained their own reserve requirements in order to facilitate trading between territories with different currencies. A history of reserve requirements from the Fed (PDF) outlines this example:
To facilitate the more widespread use of their notes, banks in New York and New England entered into voluntary redemption arrangements as early as 1820. Under these arrangements, one bank agreed to redeem another bank’s notes at par, provided that the issuing bank maintained a sufficient deposit of specie (gold or its equivalent) on account with the redeeming bank as backing for the notes.
It wasn’t until after the Civil War when the federal government stepped in to establish national reserve requirements, and there was no central bank until the creation of the Federal Reserve in 1913. The first national reserve requirement was 25% for all banks; the original rates set by the Fed were between 12-18% depending on the type of bank (ibid. Feinman). Today, a bank’s reserve requirement depends upon its size in net transaction accounts, and different types of deposits have different requirements. Requirements range from 0-10%, and you can see the full list on the Fed’s Monetary Policy site.
So, what do today’s reserve requirements mean for banks, and what do they mean for you? Reserve ratios are less powerful than some tools the Fed uses to regulate the money supply, but they do change the way banks work. Since different types of deposits carry different requirements, banks have an incentive to keep more of their money in deposits with little or no reserve requirements. Money Market Deposit Accounts (MMDAs) have lower reserve requirements than other customer deposits, so banks prefer to have more of their money in MMDAs. In order to avoid high reserve requirements, banks can move your money into MMDAs before the Fed looks at the bank’s balances for the day. In a paper for the Federal Reserve Bank of St Louis (PDF), economists describe the software banks use for “deposit sweeps,” or re-allocating deposits:
At its start, deposit-sweeping software creates a “shadow” MMDA deposit for each customer account. These MMDAs are not visible to the customer, that is, the customer can make neither deposits to nor withdrawals from the MMDA. To depositors, it appears as if their transaction-account deposits are unaltered; to the Federal Reserve, it appears as if the bank’s level of reservable transaction deposits has decreased sharply.
Banks make these changes before the close of business on one day, and change everything back before the start of the next day. By lowering the total amount of their required reserve, the bank may lend or invest more money than they could if they hadn’t reclassified your deposit. Of course, most banks keep all the extra money they earn by avoiding higher reserve requirements.
An Interest-ing Question
Like any bank, the Federal Reserve has always paid interest on deposits from other banks. As of 2008, the Fed also pays interest on reserve requirements, so banks earn some money (0.25%) on these funds. It’s not enough to discourage deposit sweeps, but it is enough to help stabilize the market because it allows the Fed to add money to the economy without taking more drastic measures.
If reserve requirements were too high, banks wouldn’t have money to lend or invest in the economy, and we’d be in big trouble. Too low, and there would be no reason for banks not to lend or invest all the money we deposit.