Reserve Requirement as a Monetary Policy Instrument

The Department for Monitoring and Analysis of the Central Bank of BiH has prepared a text on the reserve requirement instrument, reports the BiH news agency Patria.

The use of the reserve requirement instrument in conducting monetary policy can be viewed through three basic functions: the prudential control function, the monetary control function, and the liquidity management function. The prudential function is historically linked to the gold standard, where gold reserves held by banks with another bank (before the emergence of central banks) ensured liquidity, i.e., the payment of liabilities. Through this system, banks protected their liquidity and solvency and ensured their operations. The monetary control function implies direct control of the central bank over monetary aggregates. By increasing the reserve requirement rate, the central bank can influence the reduction of money in circulation, or by decreasing the reserve requirement rate, it directly affects the increase in the amount of money in circulation. In this way, the central bank applies restrictive or expansive monetary policy. The liquidity management function plays a similar role. Both of the aforementioned functions affect the level of interest rates on loans and deposits.

WHAT IS A RESERVE REQUIREMENT

The concept of a reserve requirement in banking emerged at the beginning of the nineteenth century and ensured the liquidity of a bank's liabilities by requiring a given bank to deposit reserves with another bank in the form of high-quality and quickly convertible assets, most often gold. Initially, holding reserves in this way with another bank was purely voluntary and was used for one bank to accept money from another, all before the use of national currencies. Banks issued their own banknotes, and with the reserves they held with another bank, they ensured the convertibility of those banknotes. As time passed, the role of monetary policy also changed, and consequently, the reserve requirement became less of a source of liquidity and more of a mechanism to influence banks' credit expansion.

When determining reserve requirement policy, the central bank starts from the defined goals of monetary policy. These goals can include high employment, economic growth, price stability, interest rate stability, financial market stability, all depending on the economic conditions in the given circumstances, as explicitly stipulated by law. Different goals require different structural reserve requirement policies within the overall monetary policy instruments. The reserve requirement can create stable demand for reserve balances, and many central banks in developed countries use the reserve requirement for this purpose.

Reserve Requirement in Bosnia and Herzegovina

The monetary policy of the Central Bank of BiH is a mix of two concepts. One concept is discretionary monetary policy (monetary policy with discretionary power to apply monetary instruments – reserve requirement rates), and the other (predominant) is rule-based monetary policy (fixed exchange rate and automatic conversion of foreign means of payment into domestic means of payment). The reserve requirement has been applied in BiH since the establishment of the currency board arrangement in 1997. Initially, it was applied at a fairly simple level in accordance with the structure of the banking sector, and later over the years, it was used in the context of economic trends in the country (expansion and crisis).

The reserve requirement is a classic instrument of monetary and credit policy. Under the conditions of monetary regulation, as is in force in BiH, the reserve requirement represents the sole and primary instrument of the monetary policy of the Central Bank of BiH. The reserve requirement mechanism provides the Central Bank of BiH with the possibility to regulate the credit potential of commercial banks in the short term within the framework of current monetary policy by adjusting the reserve requirement rate. The base on which the reserve requirement is calculated includes a wide range of liability items on the banks' balance sheets, containing elements from deposit money to long-term deposits. Regardless of how the base is determined, on a narrow or broad basis, the goal of its regulation is to reduce or increase the liquidity of the banking sector. The determination of the base for calculating the reserve requirement can influence monetary, and thus economic, developments in the economy of Bosnia and Herzegovina.