Friday, September 28, 2012

Why do commercial banks react to changes in central bank base rates?

Darned if I know.
The amount of reserves that commercial banks need to hold as a proportion of their total assets or liabilities varies from country to country. In some countries (e.g. Canada) there is no minimum reserve requirement. In the latter sort of countries, commercial banks’ only reason for holding reserves is to enable them to settle up amongst themselves.
As to what reserves are relative to M4 or commercial bank lending, this has varied over the last five years from a ratio of about 1:10 to about 1:20 in the UK.
Now if a commercial bank needs £1 of reserves for every £20 lent, the fact of it having to pay an extra percent or two to obtain those reserves will have a negligible effect on the rate it charges for lending the £20.
So why do changes in central bank base rates have any effect on commercial bank lending?
Anyone know?

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