Reserve requirements

What Are Reserve Requirements?

Reserve requirements are regulations set by a central bank that dictate the minimum amount of cash or highly liquid assets that commercial banks and other depository institutions must hold in reserve against customer deposits. These reserves are typically held either as cash in the bank's vault (vault cash) or as balances at the central bank. The primary purpose of reserve requirements is to enable the central bank to influence the amount of money available for lending in the economy, thereby acting as a tool of monetary policy. By adjusting the reserve requirements, central banks can impact the liquidity within the banking system and, consequently, affect interest rates and the overall economic growth.

History and Origin

The concept of reserve requirements has roots stretching back centuries, with early forms existing even before the establishment of modern central banking. Historically, these requirements were seen as a way to ensure the financial stability of individual banks, providing a buffer against unexpected withdrawals and helping to prevent bank runs. However, experience, particularly during periods of financial stress like the Great Depression, demonstrated that reserves held for this purpose were often insufficient to avert widespread panic.

In the United States, reserve requirements were first established at the national level with the passage of the National Bank Act in 1863. Initially, these requirements aimed to secure the liquidity of bank notes and deposits.¹² Over time, particularly after the creation of the Federal Reserve System in 1913, the role of reserve requirements shifted from a primary focus on bank liquidity to becoming a tool for implementing monetary policy.¹¹

For many years, reserve requirements played a central role in guiding the behavior of banks and managing the money supply. However, their significance diminished over time, particularly as central banks developed other tools for monetary management, such as open market operations and adjustments to the interest paid on reserves. In a significant shift, the Federal Reserve reduced reserve requirement ratios to zero percent, effective March 26, 2020, effectively eliminating them for all depository institutions. This action was taken to support the flow of credit to households and businesses amidst the economic impact of the COVID-19 pandemic.¹⁰

Key Takeaways

• Reserve requirements are the minimum reserves that depository institutions must hold against customer deposits, as mandated by the central bank.
• Historically, they served as a prudential measure for bank liquidity and a tool for monetary policy to influence lending and the money supply.
• In the United States, the Federal Reserve reduced reserve requirement ratios to zero percent in March 2020, eliminating them for all depository institutions.⁹
• Globally, the purpose of reserve requirements can vary, serving prudential, monetary control, and liquidity management functions.⁸

Formula and Calculation

Prior to the elimination of reserve requirements in the United States in 2020, the calculation for required reserves was straightforward:

Where:

• Required Reserves: The dollar amount that a commercial bank must hold in reserve.
• Reserve Requirement Ratio: The percentage set by the central bank.
• Deposits: The total amount of transaction deposits (e.g., checking accounts) held by the bank.

For example, if a bank had $100 million in deposits and the reserve requirement ratio was 10%, it would need to hold $10 million in reserves. The remaining $90 million would be considered excess reserves, which could then be used for lending.

Interpreting Reserve Requirements

The interpretation of reserve requirements depends heavily on the specific monetary policy framework of a country's central bank. In a system where reserve requirements are actively used, a higher ratio generally signals a contractionary monetary policy stance, aiming to reduce the money supply and curb inflation. Conversely, a lower ratio indicates an expansionary policy, intended to increase the money supply and stimulate economic activity by encouraging lending.

However, in jurisdictions like the United States where the central bank operates under an "ample reserves regime," the direct impact of reserve requirements on monetary policy implementation is minimal or non-existent. The Federal Reserve, for instance, explicitly stated that reserve requirements do not play a significant role in its current operating framework after reducing them to zero.⁷ In such a system, the central bank influences short-term interest rates primarily through setting the interest rate it pays on reserve balances that banks hold at the central bank, and through open market operations.

Hypothetical Example

Imagine a country, "Financia," where the central bank still uses reserve requirements as an active tool.

Scenario:
A new commercial bank, "Growth Bank," opens with $500 million in customer deposits. The Financia Central Bank has set the reserve requirement ratio at 8%.

Step-by-Step Walkthrough:

1. Calculate Required Reserves: Growth Bank must determine how much of its deposits it needs to hold in reserve.
   Required Reserves = 8% of $500,000,000 = $40,000,000

2. Determine Available Funds for Lending: The amount not held in reserve is available for lending or investment.
   Available Funds = $500,000,000 - $40,000,000 = $460,000,000

Growth Bank can now use this $460 million to issue loans, buy securities, and engage in other financial activities. If the Financia Central Bank later decided to stimulate the economy, it might lower the reserve requirement to, say, 5%. This would free up an additional $15 million (3% of $500 million) for Growth Bank to lend, potentially increasing the money supply and stimulating economic growth.

Practical Applications

While their direct use as a monetary policy tool has evolved, reserve requirements (or their absence) have several practical applications and implications within the financial system:

• Monetary Policy Tool (Historically and Internationally): Many central banks globally continue to utilize reserve requirements to manage liquidity and influence interest rates, particularly in emerging markets. The International Monetary Fund (IMF) has extensively studied their evolving role, noting their use for prudential, monetary control, and liquidity management purposes across different countries.⁶,⁵
• Bank Balance Sheet Management: Even without explicit requirements, banks must still manage their balance sheet and liquidity carefully. The absence of reserve requirements in the U.S. means banks have greater flexibility in how they deploy their funds, though they remain subject to other prudential regulations like capital requirements and liquidity ratios.
• Impact on Lending Capacity: When reserve requirements were in place, reducing them would immediately increase the amount of funds available for banks to lend, potentially stimulating credit creation. Conversely, increasing them would restrict lending. This direct link influences the cost and availability of credit in the economy.
• Financial Stability: While not their primary function in modern frameworks, reserve requirements historically aimed to bolster financial stability by ensuring banks held a buffer. Other regulatory tools, such as stress tests and capital adequacy rules, have largely supplanted this role in developed economies.

Limitations and Criticisms

Despite their historical importance, reserve requirements have faced significant limitations and criticisms, leading many major central banks, including the Federal Reserve, to reduce or eliminate them.

One primary criticism is that they act as a tax on banks. By forcing banks to hold a portion of their deposits uninvested (or at a low interest rate at the central bank), reserve requirements can reduce banks' profitability compared to an environment where they could lend out all available funds.⁴ This "reserve tax" can disproportionately affect smaller banks or those with a higher proportion of reservable liabilities.

Furthermore, in modern financial systems with sophisticated money markets and open market operations, reserve requirements became less effective as a precise tool for controlling the money supply. Banks often hold significant excess reserves beyond what is required, making changes to the mandated ratio less impactful on their actual lending behavior. This was particularly evident after the 2008 financial crisis when central banks significantly expanded their balance sheets through quantitative easing, leading to an abundance of reserves in the banking system.

The move by the Federal Reserve in March 2020 to reduce reserve requirement ratios to zero highlights this shift. The Board stated that reserve requirements "do not play a significant role" in its ample reserves operating framework, and their elimination was intended to "support lending to households and businesses."³ This action effectively removed what many viewed as an outdated and inefficient regulatory burden without affecting the central bank's ability to implement monetary policy.

Reserve Requirements vs. Capital Requirements

While both reserve requirements and capital requirements are forms of bank regulation aimed at promoting financial stability, they serve fundamentally different purposes and operate on different aspects of a bank's balance sheet.

Reserve requirements dictate the percentage of a bank's deposits that must be held in liquid form (cash or balances at the central bank). Their primary historical goal was to ensure banks had enough immediate liquidity to meet withdrawal demands and, more recently, to serve as a monetary policy tool to influence the money supply. They focus on the liability side (deposits) and the immediate liquidity of assets.

In contrast, capital requirements mandate the minimum amount of capital (equity and certain other loss-absorbing instruments) that a bank must hold relative to its risk-weighted assets. Their core purpose is to ensure that banks have sufficient financial buffers to absorb potential losses from their lending and investment activities without becoming insolvent. Capital acts as a cushion against unexpected losses, protecting depositors and the broader financial system. They focus on the asset side (risks) and the long-term solvency of the bank. While reserve requirements address liquidity, capital requirements address solvency and risk absorption.

FAQs

Why did the Federal Reserve eliminate reserve requirements?

The Federal Reserve eliminated reserve requirements in March 2020 because they were no longer deemed a necessary tool for implementing monetary policy in an "ample reserves" environment.² The Fed now primarily manages interest rates through other methods, such as adjusting the interest it pays on reserve balances held by banks. Removing reserve requirements was also intended to reduce administrative burden on banks and support lending during economic uncertainty.

Do other countries still have reserve requirements?

Yes, many countries, particularly emerging economies, still maintain and actively use reserve requirements as a tool for monetary policy and liquidity management. Their application varies widely, and their specific roles can include controlling the money supply, managing capital flows, and promoting financial stability.¹

How do reserve requirements affect the money supply?

When reserve requirements are in place and actively used, an increase in the ratio means banks must hold more reserves and have less money available for lending, which tends to decrease the money supply. A decrease in the ratio allows banks to lend more, expanding the money supply. This mechanism relies on the money multiplier effect, where initial lending leads to new deposits and further lending throughout the banking system.