Reserves: What, Why, and How?

The topic of reserves is extremely important. For different types of firms, having a sufficient amount of reserves is critical for future business. In order to see why reserves has a great impact on future endeavors of various companies, we can explore the "what", "why" and "how" of the term.

What are reserves?
The definitions alters a little depending on the type of firm it is. For banks, it is the amount of money that is physically held within each branch of banks. Most banks have to keep a minimum number (reserve requirement) that will enable them to handle the financial transactions throughout the day. For insurance companies, it is similar, but varies on the payout structure. Insurance companies' reserves are the amount of money it holds so that it will be able to pay future policy benefits. The reserves are usually equal to future benefits minus future premiums to be collected. In essence, the generalized definition of reserves is the amount of money a firm keeps on hand so they can handle future business activities.

Why do firms keep reserves?
The purpose of keeping reserves follows the definition, to be able to conduct future activities. Banks use deposits to handle business activities such as investments and loans to other firms. This is a form of them borrowing money from its customers. However, customers will occasionally make withdrawals. That process is the form of customers getting their loan to the banks repaid. The banks must have an amount of money on hand to conduct withdrawals. This same notion applies for insurance companies. Insurance companies issue out various types of policies. They have some that pay in the event of a death and those that pay in the event of survival. In either case, should the policy holder fulfill his or her requirement, a benefit must be paid out. Insurance companies must have an amount that is sufficient enough to handle multiple benefit payments (Remember, insurance companies have MANY policy holders.)

How do reserves diminish risk?
Having a sufficient amount of reserves on hand can keep firms in great standing. For example, banks that issue loans issue them in the thoughts that those loans will not be defaulted on. In our current economic crisis and our housing market, it is evident that this is not the case. Banks that have a large enough amount of reserves can still conduct daily transactions and other business endeavors, even in the event their issued loans are not repaid. If not, those banks will actually have to borrow more money, maybe even from another bank. And one thing we continue to learn is that people are less willing to lend you money when you need. In addition, they are less willing to lend you money when you have a higher default risk. Therefore, having a safety net of reserves helps in decreasing your chances of default risk. Plus, it helps decrease the risk of that firm going bankrupt.

Looking at the three elements above, it is clear that the idea of reserves is critical to firms. It helps businesses better position themselves for future business activities while creating a safety net in the case of financial trouble. And judging from our wave of ups and downs in the economy, it is better to be safe than sorry.

(Information for this posted was gathered from current and previous classes. They include RMi 4350, AS 4350, FI 4000)