Lagged Reserves

What are Lagged Reserves?

Lagged reserves is a method to calculate the required level of bank reserves kept on hand or with a Federal Reserve bank. The required reserve amount is based on the value of the bank's demand deposit accounts from the previous two weeks.

Understanding Lagged Reserves

Reserves represent the amount of cash that banks must keep as paper notes in their vaults or on account at the closest Federal Reserve bank to back deposits made by their customers. Because banks operate on a system of fractional reserves, no bank keeps enough cash on hand to cover deposits should all of a bank's customers withdraw their money at the same time.

This is because most money never exists in physical form as Federal Reserve notes. Instead, money is created as accounting entries in a bank's accounts when it is lent to borrowers and then circulated through the economy. Banks need to hold enough physical cash (or liquid deposits of their own at the Fed) to pay their immediate liabilities, including customer deposit account withdrawals and payments on other debts. 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. 

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

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 total deposits can 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 (checking) accounts from two weeks earlier.

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).  

History of Lagged Reserves

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.

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