A difficult balance

A bank has a trade-off to manage. If it ties up a very high proportion of its money in reserves it loses the opportunity to lend that money to gain a decent return, but the managers can feel very safe, as they are unlikely to run out of cash. Yet if it goes for maximum interest by lending the vast majority of the money deposited long term, it could run out of cash. Thus it has to have enough reserves to avoid one or more of the following costly actions to quickly raise money: (a) borrowing from other banks; (b) selling securities; (c) borrow­ing from the central bank; or (d) reducing its loans. Required and excess reserves provide insurance against incurring liquidity problems due to deposit outflows, but like all insurance it comes at a high price.