What Is Reserve Requirement?
A reserve requirement is a central bank regulation that mandates the minimum amount of liquid assets, typically cash, that a commercial bank must hold against its deposits. This required amount, often expressed as a percentage of the bank's total deposits, is known as the reserve ratio. As a key tool within monetary policy, reserve requirements allow a central bank to influence the money supply and liquidity within the financial system. The primary objectives of setting a reserve requirement include maintaining bank solvency, controlling credit expansion, and stabilizing the economy.
History and Origin
The concept of banks holding reserves against their deposits has historical roots, evolving significantly with the development of central banking. In the United States, formalized reserve requirements were first established at the national level with the passage of the National Bank Act of 1863. This act aimed to create a more stable and uniform banking system. Prior to this, various states had differing or no legal reserve requirements. The Federal Reserve Act of 1913, which established the Federal Reserve System, further solidified the role of reserve requirements as a tool for monetary policy, authorizing the Board of Governors to set these requirements within specified ranges. For many decades, these requirements were a fundamental component of how the Federal Reserve managed the economy, influencing bank lending and overall credit availability. On March 15, 2020, in response to the COVID-19 pandemic, the Federal Reserve Board reduced reserve requirement ratios to zero percent, effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.7
Key Takeaways
- A reserve requirement is the percentage of customer deposits that a commercial bank must hold in reserve, either in its vault or at the central bank.
- Central banks use reserve requirements as a monetary policy tool to manage the money supply, influence credit, and promote financial stability.
- Increasing the reserve requirement reduces the amount of money banks can lend, potentially slowing inflation.
- Decreasing the reserve requirement frees up funds for lending, potentially stimulating economic growth.
- Many central banks, including the U.S. Federal Reserve, have reduced or eliminated reserve requirements in recent years, shifting to other monetary policy tools.
Formula and Calculation
The calculation of a bank's required reserves is straightforward. It is determined by multiplying the bank's total eligible deposits by the prevailing reserve ratio set by the central bank.
For example, if a central bank sets a reserve ratio of 10% and a commercial bank has ( $100 ) million in eligible deposits, its required reserves would be:
This means the bank must hold ( $10 ) million in reserve and can, in theory, lend out the remaining ( $90 ) million.
Interpreting the Reserve Requirement
The reserve requirement serves multiple purposes for a central bank and the broader financial system. From a prudential standpoint, it ensures that banks maintain a minimum level of liquidity to meet unexpected withdrawals and manage day-to-day payment obligations. This helps to safeguard against bank runs and contributes to overall financial stability. From a monetary policy perspective, changes in the reserve requirement ratio can significantly impact the amount of funds available for lending in the economy. A higher ratio restricts lending and can reduce the money supply, potentially curbing inflationary pressures. Conversely, a lower ratio increases the funds available for lending, which can stimulate economic activity and foster economic growth. However, its direct impact as a primary monetary policy tool has diminished in many developed economies.
Hypothetical Example
Consider "Horizon Bank," a hypothetical commercial bank with total eligible deposits of $500 million.
Historically, if the central bank set a reserve requirement of 5%, Horizon Bank would calculate its required reserves as follows:
Required Reserves = $500,000,000 (Total Deposits) × 0.05 (Reserve Ratio) = $25,000,000.
This means Horizon Bank would be required to hold $25 million in reserve. The remaining $475 million could be used for lending to individuals and businesses, contributing to the broader money supply through the fractional reserve banking system.
If the central bank were to lower the reserve requirement to 3%, Horizon Bank's required reserves would drop to $15 million ($500,000,000 × 0.03). This would immediately free up an additional $10 million ($25 million - $15 million) in funds that Horizon Bank could potentially lend out, injecting more liquidity into the economy.
Practical Applications
Historically, reserve requirements have been a fundamental tool for central banks in managing the money supply and influencing credit conditions. By adjusting the reserve ratio, monetary authorities could directly impact the volume of funds that commercial banks had available for lending. For instance, raising the reserve requirement would reduce the funds banks could lend, leading to higher interest rates and a contraction in the money supply, used to combat inflation. Conversely, lowering the reserve requirement would expand the available funds, encouraging lending, lowering interest rates, and stimulating economic growth.
However, in many modern economies, particularly in developed nations like the United States, the direct use of reserve requirements as a primary monetary policy instrument has waned. Since March 26, 2020, the Federal Reserve reduced the reserve requirement ratios for all depository institutions to zero. T6his shift reflects a move towards an "ample-reserves" framework, where the central bank manages liquidity primarily through the administration of administered rates, such as the interest paid on reserves, rather than through direct quantity controls via reserve requirements. Nevertheless, reserve requirements remain a tool in the arsenal of some central banks, especially in developing or emerging markets, to address issues like capital flows or financial stability concerns.
5## Limitations and Criticisms
While historically significant, the effectiveness and utility of the reserve requirement as a monetary policy tool have been subjects of considerable debate and criticism, leading many central banks to reduce or eliminate them.
One major criticism is that reserve requirements can act as a "tax" on commercial banks. F4unds held to meet the reserve requirement typically earn little to no interest, representing an opportunity cost for banks that could otherwise lend out those funds to generate revenue. This can put regulated depository institutions at a competitive disadvantage compared to less regulated financial entities or those in jurisdictions with lower reserve requirements.
Furthermore, changes to reserve requirements are often considered a blunt instrument for managing the money supply. Even small adjustments can have a significant and sometimes unpredictable impact across the entire financial system. Modern monetary policy increasingly favors more precise and flexible tools, such as open market operations and administered interest rates, which allow central banks to fine-tune liquidity conditions more smoothly. As financial innovation, like "sweep accounts," has allowed banks to reclassify deposits to avoid reserve requirements, their practical impact on controlling the money supply has also diminished.
3Some argue that reserve requirements are not strictly necessary for monetary control if a stable demand for voluntarily held reserves exists, or if the central bank can effectively manage short-term interest rates through other means. M2oreover, in a fractional reserve banking system, the ability of banks to create money through lending is not solely determined by the reserve ratio but also by demand for loans and the availability of capital.
Reserve Requirement vs. Capital Requirement
Although both are regulatory tools affecting bank operations, the reserve requirement and capital requirement serve distinct purposes.
A reserve requirement mandates the minimum amount of liquid funds that a bank must hold against its deposits. Its primary historical aim was to control the money supply and ensure a basic level of liquidity to meet customer withdrawals. It focuses on the liability side of a bank's balance sheet (deposits).
In contrast, a capital requirement dictates the minimum amount of a bank's own funds (equity and certain forms of debt) that it must hold relative to its risk-weighted assets. This regulation is designed to ensure a bank's long-term solvency and ability to absorb potential losses from its assets (such as loans and investments). It focuses on the asset and equity side of a bank's balance sheet, acting as a buffer against financial shocks and promoting overall financial stability. While reserve requirements influence the immediate lending capacity, capital requirements affect a bank's risk-taking behavior and its ability to withstand adverse economic conditions.
FAQs
What is the current reserve requirement in the United States?
As of March 26, 2020, the Federal Reserve reduced the reserve requirement ratios for all depository institutions to zero percent. This means banks in the U.S. are not formally required to hold a specific percentage of their deposits as reserves.
1### Why do central banks impose reserve requirements?
Historically, central banks imposed reserve requirements primarily to control the money supply and ensure banks had enough liquidity to meet customer withdrawals, thus promoting financial stability. They acted as a tool to influence lending and economic activity.
How does a change in the reserve requirement affect the economy?
In theory, increasing the reserve requirement reduces the amount of money banks can lend, which tends to contract the money supply, raise interest rates, and slow inflation. Conversely, decreasing it allows banks to lend more, expanding the money supply, lowering interest rates, and stimulating economic growth. However, its direct impact as a policy tool has diminished in many advanced economies due to other monetary policy instruments and financial innovations.
Is the reserve requirement the same as bank capital?
No. A reserve requirement dictates the liquid assets a bank must hold against its deposits, primarily for liquidity purposes. Capital requirements, on the other hand, specify the minimum amount of a bank's own funds (equity) it must hold relative to its risks, aiming to ensure solvency and protect against losses.