What it means
Reserves come in two broad kinds. Statutory or required reserves are set by law or regulation, such as the share of customer deposits a bank must hold at the central bank.
Voluntary reserves are the extra amounts the organisation holds because its own managers or directors decide to. In banking, the voluntary portion is often called excess reserves.
Banks hold more than required to handle sudden withdrawals, to settle payments smoothly and to reassure depositors during uncertain times. The cost is that cash sitting idle earns little or nothing compared with lending it out.
In a company, a voluntary reserve is a part of retained earnings (profits kept in the business instead of paid out) that is earmarked for a purpose, such as equipment replacement, expansion or contingencies. Directors can create or release it by a decision, and it is usually shown in the equity section of the balance sheet.
Setting one up does not by itself create cash, because it is an accounting label on profits that have already been earned. That point is often misunderstood.
A reserve is a claim on profits, but the cash may already have been spent on stock or equipment. To make a reserve genuinely useful, the company should also hold liquid assets, such as cash or short-term deposits, to match it.
Voluntary reserves have trade-offs. They improve resilience and can reassure lenders, but they reduce the amount available for dividends or investment.
A reserve that is too large can mean the business is under-using its capital. Reserve policy should be reviewed regularly.
Managers can revisit the purpose, the target level and the conditions under which the reserve will be spent, so that it remains relevant as the business changes.
In practice
Real-world examples.
Example
A mid-sized bank keeps $6,000,000 above its required reserves during a period of market stress. When several large depositors withdraw funds in one week, the bank meets the requests without selling assets at a loss. The extra cushion avoids a liquidity scare.
Example
A family-owned manufacturer allocates $500,000 of profits each year to an equipment replacement reserve. The board resolves to hold this amount in a separate deposit account. When a key machine fails, the company pays for a replacement from the reserve without borrowing.
Example
A charity sets a policy to hold six months of operating costs as a voluntary reserve. The trustees review it annually, and they explain the target to donors so the money is not seen as hoarded. The reserve allowed the charity to keep services running during a delay in grant payments.
Formula
Calculation
Voluntary reserve = Total reserves actually held - Required reserves
A bank holds customer deposits of $200,000,000. The regulator requires reserves of 10%, so required reserves are $200,000,000 x 10% = $20,000,000. The bank actually holds $26,000,000 in reserves. Voluntary (excess) reserves = $26,000,000 - $20,000,000 = $6,000,000. This is 3% of deposits, held as an extra safety buffer rather than lent out.Case study
Seen in the real world.
Windermere Insurance is an illustrative, fictional insurer that must hold a regulatory minimum of $40,000,000 in capital. Its board decided to keep an additional voluntary reserve of $10,000,000 after reviewing a year of unusually high claims.
The extra reserve cost the company some investment return, estimated at $400,000 a year if the money had been invested at a higher-risk rate of 4%. Management accepted that cost to keep a buffer above the regulatory floor.
In the following year, a severe storm led to claims $12,000,000 above forecast. The illustrative company absorbed the loss without breaching its minimum and without raising emergency capital, which protected its rating and its customers. After the event, the board reviewed the reserve policy and decided to rebuild the voluntary reserve to $10,000,000 over two years from retained profit. It also agreed to document the circumstances in which the reserve could be used, so that future boards would apply it consistently.
Watch out
Common mistakes.
- Believing a reserve on the balance sheet is a pile of cash, when it is often just a label on retained profits.
- Building a very large reserve without a clear purpose, which ties up capital that could be invested or paid out.
- Confusing voluntary reserves with required reserves, which are set by law and are not a matter of choice.
Questions
People also ask.
Why would a bank hold more than the required amount?
It does so for safety, to cover unexpected withdrawals and payment demands, even though idle cash earns little.
Where does a company show a voluntary reserve?
It is normally shown within equity on the balance sheet as a part of retained earnings set aside by the directors.
Can directors release a voluntary reserve?
Yes, because it is created by their own decision, they can usually move the amount back into general retained earnings.
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