Why doesn’t the Federal Reserve require Banks to Hold Depositors’ Cash?

The Federal Reserve Board reduced banking reserve requirements to zero in March 2020, sparking concerns about the safety of depositor money in the United States. With several banks like Silvergate Bank, Silicon Valley Bank, and Signature Bank shutting down, people are questioning whether regional banks pose the same risks. The flawed system of fractional reserve banking has only gotten worse with the zero reserve policies at the Federal Reserve.

The Problem with Fractional Reserve Banking

Before the pandemic, banks had to hold 10% of deposits in cash. However, the bank didn’t have to hold the entire deposit under fractional reserve banking. For instance, if a depositor puts $1,000 in the bank, the bank would hold $100 and loan out $900 to borrowers through mortgages, car loans, etc. Banks charge interest on these loans, and account holders receive a meager interest.

While fractional reserve banking allows banks to keep only a portion of the depositor’s money while lending most of it, it also creates a risk that the bank might not have enough cash reserves to fulfill all withdrawal requests. Unfortunately, this happened when everyone came for their money in Silicon Valley Bank (SVB).

Silicon Valley Bank as an Example

Approximately 1,000 startups had invested their money in Silicon Valley Bank, with some holding millions. If the bank had failed, it could have wiped out all these startups. Furthermore, major publicly traded companies like Roku had almost a quarter of their cash at SVB. However, only 2.7% of SVB deposits were FDIC-insured since the agency had a $250,000 depositor limit. Therefore, most depositors wouldn’t have been covered if the bank failed.

SVB holds a ton of treasuries on its balance sheets, and banks hold a lot of treasuries in general. Hence the Fed’s decision to increase or decrease the Fed funds rate can have far-reaching effects on the economy. When the value of treasuries decreases, the yield of treasuries increases, and banks that don’t manage risk can go bust.

Related Facts

• The FDIC only has about $120 billion and wouldn’t have covered most people with funds at SVB.
• SVB is considered the second-largest bank failure in U.S. history after Washington Mutual, with $212 billion on its balance sheet.

Key Takeaway

The Federal Reserve’s decision to reduce banking reserve requirements to zero has increased the risks associated with fractional reserve banking. In the event of a bank’s failure, most depositors might not be insured by the FDIC. The Fed’s actions and policies have sowed the seeds of the financial crisis in multiple ways.

Conclusion

The Federal Reserve should reconsider allowing banks to operate with zero cash reserves. This policy only increases the risk of bank collapses, especially during volatile economic times. In addition, regional banks need to be more transparent about their risk mitigation strategies and ensure they can manage crises effectively. The FDIC should also be given more resources to cover more depositor funds in case of a bank failure.