The reserve requirement is the total amount of funds a bank must have on hand each night. It is a percentage of the bank's deposits. The nation's central bank sets the percentage rate. The bank can hold the reserve either as cash in its vault or as a deposit at its local central bank. The reserve requirement applies to commercial banks, savings banks, savings and loan associations, and credit unions.[1]

How It Works

Say a bank has $1,000,000 in deposits. Each night, it must hold $100,000 in reserve. That allows it to lend out $900,000. That increases the amount of money in the economy. The loans help businesses expand, families buy homes, and students attend school. Having $100,000 on hand makes sure it has enough to meet withdrawals. Without the reserve requirement, the bank might be tempted to lend all the money out.

Reserve Bank of Zimbabwe's Policy Rate

Zimbabwe's central bank lowered its policy rate for the second time in 2020 and for the third time in the current easing cycle to ensure the country's economy remains on a path towards growth amid the impact of the Covid-19 pandemic.

The Reserve Bank of Zimbabwe (RBZ) cut its policy rate by another 10 percentage points to 15.0 percent and has now cut it by 20 percentage points in 2020 following a similar-sized cut in March. Since November 2019, when RBZ halved its policy rate to 35.0 percent from 70.0 percent, the rate has now been cut by 55 percentage points in three steps.

During the 2020 Mid-Term Monetary Policy Review presentation on 21 August 2020 the Governor pronounced that, in order to curb speculative borrowing and manage foreign exchange pressures, the Bank reviewed the Bank Policy rate upwards from 15% to 35%. This was to reduce excess liquidity on the market which could be channeled towards purchasing of foreign currency thus putting pressure on the exchange rate.

In addition to the cut to the policy rate, which took effect on 1 May 2020, RBZ said the interest rate on its medium-term bank accommodation facility will be lowered to 10 percent from 15 percent while the size of the facility has been increased by another 500 million Zimbabwe dollars to 3 billion. In March, when RBZ cut its policy rate by 10 percentage points, RBZ lowered the statutory reserve ratio by 50 basis points to 4.5 percent and added 1 billion Zimbabwe dollars to the medium term accommodation facility to a total of 2.5 billion.[2] To promote production to boost exports the RBZ through its Monetary Policy Committee (MPC) resolved to reduce the statutory reserve ratio from 4.5% to 2.5% with effect from 8 June 2020.[3]

The RBZ uses these tools to control liquidity in the financial system. When the RBZ reduces the reserve requirement, it is exercising expansionary Monetary Policy. That creates more money in the banking system. When it raises the reserve requirement, it is executing contractionary policy. That reduces liquidity and slows economic activity.

How the Reserve Requirement Affects Interest Rates

Raising the reserve requirement reduces the amount of money that banks have available to lend. Since the supply of money is lower, banks can charge more to lend it. That sends interest rates up.

But changing the requirement is expensive for banks. For that reason, central banks don't want to adjust the requirement every time they shift monetary policy. Instead, they have many other tools that have the same effect as changing the reserve requirement. If the RBZ funds rate is high, it costs more for banks to lend to each other overnight. That has the same effect as raising the reserve requirement.

As the RBZ funds rate rises, these four interest rates also rise:

  • Libor is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. Banks base their rates for credit cards and adjustable-rate mortgages on Libor.
  • The prime rate is the rate banks charge their best customers. Other bank loan rates are a little higher for other customers.
  • Interest rates paid on savings accounts and money market deposits also increase.
  • Fixed-rate mortgages and loans are indirectly influenced. Investors compare these loans to the yields on longer-term Treasury notes. A higher RBZ funds rate can drive Treasury yields a bit higher.



References

  1. Kimberly Amadeo, [1], The Balance, Published: 7 July, 2020, Accessed: 14 August, 2020
  2. [2], allAfrica, Published: 1 May, 2020, Accessed: 14 August, 2020
  3. Tatira Zwinoira, [3], Newsday, Published: 9 June, 2020, Accessed: 14 August, 2020