Final answer:
The statement is true: Banks are required to hold a minimum amount of reserves but can hold excess reserves. Reserve requirements serve as a tool for bank regulation and monetary policy. During difficult economic periods, banks often increase their excess reserves to mitigate risks.
Step-by-step explanation:
Understanding Reserve Requirements and Excess Reserves
Banks are required by regulation to keep a certain minimum level of funds, known as reserves, which are not to be loaned out or invested but held either in their vaults or at the central bank, commonly referred to as the Federal Reserve Bank in the United States. The statement that banks are legally required to hold a minimum level of reserves but are not prohibited from holding additional excess reserves above this legal mandate is true. Reserves are a critical aspect of bank regulation and monetary policy, acting as a buffer to ensure that banks can meet depositors' withdrawal demands and to provide stability in the financial system.
For instance, in early 2015, the reserve requirement set by the Federal Reserve was at 0% for the first $14.5 million in deposits, 3% for deposits up to $103.6 million, and 10% of any amount above $103.6 million. While these requirements are generally adjusted annually, significant changes are rarely implemented due to the potential for disruption within the banking system. Furthermore, during economic downturns such as recessions, banks often choose to hold higher levels of excess reserves due to the increased risk of loan defaults, as the economic conditions could make it more challenging for borrowers to repay loans.
The ability to hold excess reserves allows banks flexibility in their operations and provides an additional safety net during times of financial stress. However, holding excess reserves also means that the banks are not utilizing these funds for loan creation or investments, which could otherwise lead to earning interest income. In times of economic uncertainty, banks may prioritize the security of excess reserves over the potential profits from lending.