Primary Reserves

What Are Primary Reserves?

Primary reserves are the minimum amount of cash legally required to operate a bank. Primary reserves also include the legal reserves housed in a Federal Reserve bank or other correspondent bank. Checks that have not been collected are included in this amount as well.

Understanding Primary Reserves

When a customer deposits money with a bank, the bank is required to keep a certain fraction held in reserve. A portion of deposits are held in reserve as liquid funds, while the rest is lent to borrowers or invested in less liquid assets.

Primary reserves are kept to cover normal day-to-day withdrawals and especially unexpected major withdrawals or runs of withdrawals. They serve as a defense against a substantial reduction in liquidity. These reserves must be kept more liquid than secondary reserves, which may be invested in marketable securities such as Treasury offerings. 

Primary reserves represent the base of the pyramid of credit that makes up the overall supply of money in the economy through the practice of fractional reserve banking. The vast majority of money in the economy consists of electronic or other accounting entries created out of thin air by the banks when they lend out the deposits they also hold on account on behalf of the depositors. The Federal Reserve, acting in its capacity as a regulator of the banking system, requires banks to keep some small percent of customer deposits on hand as liquid funds to pay out withdrawals, and banks are only allowed to lend out a fraction of the deposits they receive. This acts a brake on banks' ability to simply create an infinite amount of new money, as well as an opportunity cost for the banks to hold deposits as cash with little or no return for the bank. 

However, as of March 2020 the Federal Reserve eliminated reserve requirements for all depository institutions in order to free up liquidity for banks to increase lending to businesses and households. For now, the Fed does not have plans to re-impose reserve requirements in the future. 

In effect, banks now only need to hold whatever cash reserves they believe they need to cover their customer withdrawals and other liquidity needs and are not required by the Fed to hold any cash if they choose not to. The only constraint on banks in this case is the risk that holding inadequate reserves might lead to bank bankruptcies or defaults if they do not hold sufficient cash to pay their depositors and other creditors.

Since the 2007-08 Financial Crisis, this market constraint has been the binding reserve requirement for banks anyway. Since 2008, banks have held trillions of dollars in combined excess reserves above and beyond the Fed's reserve requirement.