Required reserves: Meaning, Criticisms & Real-World Uses

What Are Required Reserves?

Required reserves are the minimum amount of funds that commercial banks and other depository institutions must hold in reserve, either in their vaults as cash or as balances at their country's central bank. This mandate is a cornerstone of fractional reserve banking, a system where banks hold only a fraction of their customer deposits as reserves and lend out the rest. Required reserves serve as a regulatory tool within monetary policy, designed to influence the money supply, manage liquidity in the banking system, and ensure the financial stability of institutions.

History and Origin

The concept of banks holding reserves originated informally in the early 19th century when individual banks needed to keep a portion of their notes and deposits to manage customer withdrawals and exchanges. In the United States, formal reserve requirements were first established nationally with the passage of the National Bank Act in 1863, which mandated that banks operating under a national charter hold a 25% reserve against both notes and deposits. This measure was initially perceived as a way to ensure bank liquidity. However, as the financial system evolved and bank runs continued, it became apparent that these requirements alone had limited effectiveness in guaranteeing liquidity. With the creation of the Federal Reserve System, required reserves transitioned into a tool primarily used to reinforce the effects of other monetary policy instruments, such as open market operations, influencing overall credit conditions in the economy⁷. In a significant shift, the Board of Governors of the Federal Reserve System reduced reserve requirement ratios to zero percent, effective March 26, 2020, effectively eliminating them for all depository institutions⁶.

Key Takeaways

Required reserves are the fraction of customer deposits that banks are legally mandated to hold, either as vault cash or at the central bank.
They are a tool of monetary policy, historically used to influence the money supply and ensure bank liquidity.
The required reserve ratio is typically set by the central bank or monetary authority of a country.
In some major economies, such as the United States, required reserve ratios have been reduced to zero, shifting the focus of monetary policy implementation to other tools.
While the U.S. eliminated reserve requirements, other central banks, like the European Central Bank, continue to impose minimum reserve requirements on credit institutions within their jurisdiction⁵.

Formula and Calculation

When required reserves are in effect, their calculation is straightforward. It involves multiplying a bank's eligible deposit accounts by the prevailing reserve requirement ratio.

The formula is:

\text{Required Reserves} = \text{Eligible Deposits} \times \text{Reserve Requirement Ratio}

Variables Defined:

Required Reserves: The absolute amount of funds a bank must hold.
Eligible Deposits: The specific types of deposits (e.g., net transaction accounts, demand deposits) against which reserves are calculated, as defined by the central bank.
Reserve Requirement Ratio: The percentage set by the central bank that dictates the portion of eligible deposits that must be held in reserve.

For example, if a bank holds $100 million in eligible deposits and the central bank sets a reserve requirement ratio of 10%, the bank's required reserves would be $100 million * 0.10 = $10 million.

Interpreting Required Reserves

The interpretation of required reserves depends heavily on the prevailing monetary policy framework of a country's central bank. Historically, a higher reserve requirement ratio meant that banks had less money available to lend, which could restrict the money supply and potentially curb inflation. Conversely, a lower ratio would free up funds, encouraging lending and potentially stimulating economic growth.

In an "ample reserves" system, like the one adopted by the U.S. Federal Reserve, the direct impact of the reserve ratio on lending decisions has diminished because banks voluntarily hold significant amounts of excess reserves. In this environment, the central bank influences short-term interest rates primarily through other tools, such as the interest paid on reserves.

Hypothetical Example

Consider "Horizon Bank," a hypothetical commercial bank operating in a country where the central bank maintains a 5% reserve requirement.

Customer Deposit: A new customer opens an account at Horizon Bank and deposits $500,000 in demand deposits.
Calculation: Based on the 5% reserve requirement, Horizon Bank must hold a portion of this new deposit in reserve.
Required Reserves = $500,000 * 0.05 = $25,000.
Lending Capacity: This means that out of the $500,000 deposit, Horizon Bank must keep $25,000 as required reserves. The remaining $475,000 ($500,000 - $25,000) is available for the bank to lend out to other customers, subject to its internal lending policies and other regulatory capital requirements.

This example illustrates how a reserve requirement directly impacts a bank's immediate lending capacity from new deposits.

Practical Applications

While the role of required reserves has evolved, they continue to be a component of financial regulation and monetary policy in many parts of the world.

Money Supply Control: In economies where they are actively used, central banks can adjust the reserve requirement to expand or contract the money supply. Lowering the ratio allows banks to lend more, potentially stimulating economic growth and investment. Raising it tightens credit conditions, aiming to combat inflation.
Liquidity Management: Historically, required reserves were intended to ensure that banks held sufficient cash to meet sudden withdrawal demands, thus promoting financial stability. Although less critical for this purpose today in many developed economies due to other liquidity tools, it remains a consideration.
International Variations: While the U.S. Federal Reserve has set reserve requirements to zero, other central banks, like the European Central Bank (ECB), still implement minimum reserve requirements for credit institutions in the Eurosystem. The ECB's minimum reserves are calculated as 1% of specific liabilities on bank balance sheets, primarily customer deposits and debt securities⁴. The International Monetary Fund (IMF) also discusses reserve requirements as an instrument to influence the demand for reserves at the central bank and help achieve price and financial stability mandates³.

Limitations and Criticisms

Despite their historical significance, required reserves face several limitations and criticisms, leading some major central banks, including the U.S. Federal Reserve, to reduce their reserve requirements to zero.

One significant criticism is that changing reserve requirements can have a disruptive effect on banks' operations and liquidity management. Abrupt changes can force banks to quickly adjust their balance sheets, potentially creating volatility in short-term money markets. For this reason, central banks often prefer to use more flexible tools like open market operations and adjustments to administered interest rates.

Furthermore, in an environment of abundant bank reserves—often a result of large-scale asset purchases like quantitative easing—reserve requirements become less relevant as a binding constraint on bank lending. Banks already hold far more reserves than required, making the requirement itself a non-factor in their lending decisions. Some argue that zero reserve requirements could reduce the risk of money market turmoil and increase the supply of credit by increasing the stock of liquid assets eligible to meet supervisory regulations.

#²# Required Reserves vs. Excess Reserves

The distinction between required reserves and excess reserves is crucial for understanding a bank's financial position and the broader monetary landscape.

Required Reserves: These are the mandated minimum amount of funds that a bank must hold, determined by the central bank's reserve requirement ratio applied to eligible deposits. These funds are not available for lending or investment by the bank, as they are legally "tied up" to meet regulatory obligations.
Excess Reserves: These are any reserves held by a bank over and above the required amount. Banks may hold excess reserves for various reasons, such as precautionary measures to meet unexpected withdrawals, to facilitate payment processing, or if attractive lending opportunities are scarce. In modern monetary policy frameworks, particularly those with an "ample reserves" regime, banks often hold significant levels of excess reserves. Central banks can influence the level of excess reserves by paying interest on them, which can impact banks' incentives to lend.

The confusion often arises because both are types of reserves held by banks. However, required reserves represent a regulatory floor, while excess reserves represent a bank's voluntary holdings beyond that floor.

FAQs

What is the purpose of required reserves?

Historically, required reserves served to ensure bank liquidity and control the money supply. In many modern monetary policy frameworks, their role in liquidity management has diminished, and they are primarily seen as a tool to influence the demand for central bank reserves.

Does the U.S. Federal Reserve still have required reserves?

No, as of March 26, 2020, the U.S. Federal Reserve reduced the reserve requirement ratios for all depository institutions to zero percent, effectively eliminating them.

#¹## How do central banks influence the economy if not through required reserves?
Central banks primarily influence the economy through other monetary policy tools, such as setting benchmark interest rates (like the federal funds rate in the U.S.), conducting open market operations (buying or selling government securities), and implementing quantitative easing or tightening programs. These tools directly affect the cost of borrowing for banks and the overall liquidity in the financial system.

Are required reserves the same as bank capital requirements?

No. Required reserves are a liquidity-focused regulation determining how much cash a bank must hold against its deposits. Bank capital requirements, on the other hand, mandate that banks hold a certain amount of equity and other loss-absorbing capital relative to their risk-weighted assets. Capital requirements are primarily focused on ensuring a bank's solvency and ability to absorb losses, protecting against financial crises.