Lagged Reserves

Key Takeaways

• Lagged reserves are banks' required cash reserves based on deposits from two weeks earlier.
• The Federal Reserve set reserve requirements at zero percent in March 2020.
• Banks need to hold enough cash to cover immediate liabilities and prevent bank runs.
• Lagged reserves help banks estimate and plan for necessary cash holdings.
• Reserve requirements are a monetary policy tool, adjusted to influence economic activity.

What are Lagged Reserves?

Lagged reserves are the amount of cash that a bank is required to keep in its vaults or on deposit at a Federal Reserve bank in order to meet government requirements. The term "lagged" refers to the method of calculating the reserve level for a bank.

The reserve amount is based on the value of the bank's demand deposit accounts from the previous two weeks. The purpose of a lagged reserve is to ensure that the bank has enough money on hand to meet its anticipated expenses. Lagged reserves are also called fractional reserves.

The Federal Reserve set the rate of reserves at zero percent in March 2020, effectively eliminating the requirement for now.1

How Silicon Valley Bank Collapsed

A classic run on the bank by depositors brought down Silicon Valley Bank in March 2023.2

How Lagged Reserves Function in Banking

No bank keeps enough cash on hand to meet the demands of all of its customers if they all demanded to withdraw their savings all at once. Banks make money by using their customers' cash for new loans and other investments that will pay them more than they pay their customers in interest on their deposits.

In fact, most of the dollars circulating in our modern economy never appear in the bank in paper form. They exist as accounting entries in a bank office that are then transferred to other accounts as the money is lent out.

Still, banks need to hold enough physical cash (or liquid deposits at the Fed) to pay their immediate liabilities, including customer deposit account withdrawals. Otherwise, banks risk defaulting on their liabilities to other banks or being shut down by the Federal Deposit Insurance Company in the event of a bank run.

The requirement for fractional reserves is a way of making sure that the banks have a reasonable amount of cash on hand if there is an unanticipated level of demand.

Minimum reserve requirements are set by the Fed's board of governors as one of its monetary policy tools. As of March 2020, the Fed has set minimum reserves for banks at zero percent.3

In order to verify that banks have sufficient reserves to meet minimum requirements, the Fed needs some rule to calculate the total size of a bank’s deposits. These deposits fluctuate significantly day-to-day or even over the course of a single business day. The system of lagged reserves requires a bank's currency reserves held with the Federal Reserve to be tied to the value of its demand deposit (that is, checking) accounts from two weeks earlier.3

For example, if a bank's demand deposits were $500 million on a given date, and its reserve requirement was 10%, its currency reserves two weeks later would need to equal $50 million. This two-week lag gives banks plenty of time to ensure they have the necessary reserves (on a given day) to cover minimum reserve requirements for deposits (two weeks prior).

The Evolution of Lagged Reserve Requirements

Prior to 1968, the Federal Reserve required banks to calculate necessary reserves each week based on their deposits in that same week. Lagged reserve calculation was used from 1968 until 1984, when contemporaneous calculations were re-implemented. But the Fed reverted to the lagged calculation in 1998, in order to make it easier for banks to estimate and plan the amount of reserves they would need to hold.3

In March of 2020, the Fed dropped all required reserve ratios to zero, rendering moot the need to calculate minimum required reserves.3 The move was a part of accommodative monetary policy measures in response to the economic impact of COVID-19 outbreak and ensuing lockdowns.

Why Did the Fed Eliminate the Reserve Requirement?

During the 2007-2008 financial crisis, the Federal Reserve launched its policy of "quantitative easing," pouring an enormous amount of money into the nation's bank in the expectation that it would loan some of that money out to its customers, invest some of it in new business, and keep the economy from toppling into recession.

Instead, the banks sat on those vast reserves of cash.

The Federal Reserve eliminated the reserve requirement in part because banks tend to hold onto much more cash than the minimum levels that had been required.4

Will the Fed Reinstate the Reserve Requirement after the SVB Collapse?

The Fed has not reinstated the reserve requirement in the wake of the collapse of Silicon Valley Bank and Signature Bank, as of March 18, 2023. However, it did step in with an offer to loan banks money for up to a year on generous terms in order to deal with any liquidity issues they might face.5

It should be noted that the Federal Reserve does have other regulations that touch on bank reserve amounts. These essentially set requirements for banks to get an exemption to reserve requirements.6

What Is the Usual Bank Reserve Requirement?

Historically, the bank reserve requirement has ranged between 0% and 10%.

When the Federal Reserve wants to boost the economy, it lowers the reserve so that banks have more money to lend out to consumers and businesses.

When the Fed deems the economy is too hot for its own good, it raises the reserve so that banks have to keep more money in their vaults.