A Model of Liquidity and Bank Reserves

Abstract

We consider two economic aspects of required reserves on bank deposits, their impact on bank-intermediated investment versus direct investment and their opportunity cost. We show that Bank reserves serve as a buffer to mitigate inefficient liquidation of a bank's assets in order to meet the demand for liquidity by investors. Due to some transaction costs or information costs, investors may prefer bank-intermediated investment to direct investment. Banks offer investors competitive deposit returns compared to the liquidation value of investment to attract funds from investors. If the Federal Reserve allows banks to set their individual optimal level of reserves, this might mitigate costs associated with required reserves. If banks implement the social optimum, this may introduce additional fragility into the banking system. We argue that required reserves might lead to deadweight loss if they are set above a bank's optimally determined reserves.

Citation

Kane, S.A. and Muzere, M.L. (2005), "A Model of Liquidity and Bank Reserves", Chen, A.H. (Ed.) Research in Finance (Research in Finance, Vol. 22), Emerald Group Publishing Limited, Leeds, pp. 239-272. https://doi.org/10.1016/S0196-3821(05)22009-9