To continue on with the banking series, I will assume here you have an understanding of a firm’s balance sheet and income statements. As we go on with the series, I will start to use industry specific jargon and even pull in specific terms from my own bank, but that’s later on and by then I hope you will be an expert. So, as I mentioned in the last post, the fractional reserve banking is sometimes regulated. These regulations come from either a central body like a country’s central bank or a group like the BCBS that issues the Basel Accords.
Central banks are not like the banks you and I are familiar with; they are mainly a monetary authority that is authorized by the state to manage the state’s money supply, currency and interest rates – which is used to manage both inflation and the country’s exchange rate. They have a monopoly on the amount of cash they have as they are the printers of the states’ currencies. The central bank is a bank’s bank in the sense that they are the lenders of last resort. Thus, in their interests and also in the economy’s interest they set a minimum reserve requirement ratio for the fractional reserves method that commercial banks employ. The reserves are then stored in cash in the central banks’ vaults.
However, other nations may have a voluntary reserve requirement. So these banks in those states abide by what is called the Basel Accords. It isn’t that these banks do not hold reserves or must choose between the two. They, however, in light of past financial situations or crisis, have learned that excess reserves are a good indicator of longevity and can thus conduct favorable transactions with other commercial banks.
The Basel Accords are determined by a body constituting of member representatives from the G-20 countries who have now issued their third body of recommendations and best practices called Basel III in regard to the financial crisis of 2008. Once issued, these accords are then expected to be adopted as law in statuary form or otherwise by the member states.
Management of a commercial bank thus comes down to the fundamental golden capital requirement ratio. Banks will set a target for the ratio and when the ratio is below that target, they can response in a number of ways: either by restricting investment in new loans (assets), selling additional capital instruments (liabilities i.e. Deposits etc.), borrowing funds, securitizing illiquid assets or redeeming and selling other assets.
Reserves are however just a source of liquidity i.e. to satisfy sudden unexpected customer withdrawals. Reserves also incur costs. Cost here is the opportunity cost of the reserves sitting in the central bank while earning low interests where else it could be invested in new loans earning high interests. Other sources of liquidity also have costs to them and differ in reliability. So banks maintain an arsenal of funding sources to manage their capital requirement according to the Accords. Next we will look at those funding sources and their assigned costs.