Reserve Requirements: A Definition, History, and Example

What Are Reserve Requirements?

Reserve requirements are the amount of cash that financial institutions must have, in their vaults or at the closest Federal Reserve bank, in line with deposits made by their customers. Set by the Fed’s Board of Governors, reserve requirements are one of the three main tools of monetary policy—the other two are open market operations and the discount rate.

Banks, credit unions, and savings and loan associations must meet reserve requirements. So must U.S. branches and agencies of foreign banks, Edge Act corporations, and agreement corporations.1

On March 15, 2020, the Federal Reserve Board announced that reserve requirements ratios would be set to 0%, effective March 26, 2020. Before the change was effective on March 26, 2020, the reserve requirement ratios on net transaction accounts differed based on the number of net trade accounts at the institution.1

Federal Reserve Board. “Reserve Requirements.”

KEY TAKEAWAY:

Reserve requirements are the amount of funds a bank holds in reserve to ensure it can meet liabilities in case of sudden withdrawals.
Reserve requirements are a tool the central bank uses to increase or decrease the money supply in the economy and influence interest rates.
Reserve requirements are currently set at zero in response to the COVID-19 pandemic.

Understanding Reserve Requirements

Banks loan funds to customers based on a fraction of the cash they have on hand. The government makes one requirement of them in exchange for this ability: keep a certain amount of deposits on hand to cover possible withdrawals. This amount is called the reserve requirement, the percentage that banks must keep in reserve and are not allowed to lend.

If a bank doesn’t have enough cash to meet the reserve requirement, it borrows from other banks or the Fed’s discount window. The interest banks charge each other to borrow is called the federal funds rate, and it’s the basis for many different interest rates in the economy.

The Federal Reserve’s Board of Governors sets the requirement, and the interest rate banks get paid on excess reserves. The Financial Services Regulatory Relief Act of 2006 gave the Federal Reserve the right to pay interest on excess reserves. The influential data banks started getting paid interest was Oct. 1, 2011.2 The interest rate is the interest rate on excess reserves and serves as a proxy for the federal funds rate.

The reserve requirement is another tool the Fed has to control liquidity in the financial system. By reducing the reserve requirement, the Fed is executing an expansionary monetary policy, and conversely, when it raises the condition, it’s exercising a contractionary monetary policy. This latter action cuts liquidity and causes a cool-down in the economy.

In other words, when the Fed raises reserve requirements, banks have less to lend to consumers and businesses. That, in turn, raises interest rates. When the Fed drops reserve requirements, the opposite happens: Interest rates fall.

Reserve Requirements History

Holding reserves started with the first commercial banks during the early 19th century. Each bank had its note that was only used within its geographic area of operation. Exchanging it to another banknote in a different region was expensive and risky because of the other bank’s lack of information about funds.

To overcome this problem, New York and New Jersey banks arranged for voluntary redemption at each other’s branches. The issuing and redeeming banks both maintained an agreed-upon deposit of gold or its equivalent. Subsequently, the National Bank Act of 1863 imposed 25% reserve requirements for banks under its charge.3 Those requirements and a tax on state banknotes in 1865 ensured that national banknotes replaced other currencies as a medium of exchange.

The creation of the Federal Reserve and its constituent banks in 1913 as a lender of last resort further eliminated risks and costs required in maintaining reserves and pared-down reserve requirements from their earlier high levels.4 For example, reserve requirements for three types of banks under the Federal Reserve were set at 13%, 10%, and 7% in 1917.5

In response to the COVID-19 pandemic, the Federal Reserve reduced the reserve requirement ratio to zero across all deposit tiers, effective March 26, 2020.1 This reduction aimed to jump-start the economy by allowing banks to use additional liquidity to lend to individuals and businesses.

Dec. 23, 1913

The day President Woodrow Wilson signed the Federal Reserve Act into law, thus creating the Federal Reserve.6

Reserve Requirements vs. Capital Requirements

Some countries don’t have reserve requirements. These countries include Canada, the United Kingdom, New Zealand, Australia, and Sweden.7 Instead, some of these countries must adhere to capital requirements, which is the amount of equity a bank or financial institution must hold as required by its financial regulator.

Reserve requirements refer to the number of liquid assets a bank must hold, and they’re intended to protect the institution from runs on deposits. Capital requirements are meant to absorb losses on loans and other investments.8

Example of Reserve Requirements

For example, assume a bank has $200 million in deposits and is required to hold 10%. The bank is now allowed to lend out $180 million, which drastically decreases bank credit—the amount of money the loans the bank can make to customers.

In addition to providing a buffer against bank runs and a layer of liquidity, reserve requirements are also used as a monetary tool by the Federal Reserve. By increasing the reserve requirement, the Federal Reserve is essentially taking money out of the money supply and increasing the cost of credit. Lowering the reserve requirement pumps money into the economy by giving banks excess reserves, promoting bank credit expansion, and reducing rates.

Who Sets the Reserve Requirement?

In the United States, the Federal Reserve Board sets the reserve requirements. The Federal Reserve Board receives its authority to set reserve requirements from the Federal Reserve Act. The Board establishes reserve requirements to carry out a monetary policy on deposits and other liabilities of depository institutions.

What Does a Lower Reserve Requirement Mean?

A lower reserve requirement means the Federal Reserve is pursuing an expansionary monetary policy. The lower reserve requirement means banks do not need to keep as much cash. This gives them more money for consumer and business loans.

What Does a Higher Reserve Requirement Mean?

A higher reserve requirement means the Federal Reserve is pursuing a contractionary monetary policy. If banks have a higher reserve requirement, less money will be available to lend to consumers and businesses. However, this money will then protect the banks against possible bank failure should there be an economic downturn or a run on the bank.

Bottom Line

Reserve requirements specify the amount of cash a bank must have close at hand to cover sudden withdrawals and protect the system from bank runs by depositors. The bank can hold the reserves in a vault or at the closest Fed bank.

When the Fed raises the reserve requirement, that lowers the amount banks can lend, with a tighter money supply, banks can charge more to lend, which raises interest rates.