Reserve requirements

3 key takeaways

• Reserve requirements mandate that banks hold a certain percentage of deposits as reserves.
• These reserves are held either in the bank’s vaults or at the central bank.
• Reserve requirements are a tool used by central banks to control money supply and ensure financial stability.

What are reserve requirements?

Reserve requirements are regulatory mandates imposed by central banks that dictate the minimum amount of reserves a commercial bank must hold relative to its deposit liabilities.

These reserves can be held in the form of cash in the bank’s vault or as deposits with the central bank. The primary purpose of reserve requirements is to ensure that banks maintain enough liquidity to meet depositor demands and to control the money supply in the economy.

Importance of reserve requirements

Reserve requirements serve several crucial functions in the banking system and the broader economy:

• Liquidity management: By ensuring that banks hold a portion of their deposits in reserve, central banks help maintain liquidity and ensure that banks can meet withdrawal demands from customers.
• Monetary control: Reserve requirements are a key monetary policy tool that central banks use to influence the money supply. By adjusting reserve requirements, central banks can either encourage or restrict the amount of money that banks can lend, thereby influencing economic activity.
• Financial stability: Maintaining adequate reserves helps prevent bank runs and promotes overall financial stability by ensuring that banks have sufficient funds to cover withdrawals.

How reserve requirements work

Reserve requirements are typically expressed as a percentage of a bank’s total deposit liabilities. The central bank sets this percentage, and banks must comply by holding the specified amount in reserves.

Calculation of reserve requirements

For example, if the reserve requirement is set at 10%, a bank with $1 billion in deposits would be required to hold $100 million in reserves.

Reserve Requirement = Deposit Liabilities * Reserve Ratio

Reserve Requirement = $1,000,000,000 * 0.10 = $100,000,000

Types of reserves

1. Required reserves: The minimum amount of reserves that a bank must hold, as mandated by the central bank.
2. Excess reserves: Any reserves held by a bank beyond the required minimum. Banks may hold excess reserves as a precautionary measure or to earn interest if the central bank pays interest on reserves.

Impact of changing reserve requirements

Adjusting reserve requirements can have significant effects on the banking system and the economy:

• Increasing reserve requirements: When the central bank raises reserve requirements, banks must hold a larger portion of their deposits in reserve. This reduces the amount of money available for lending, which can decrease the money supply and slow economic activity.
• Decreasing reserve requirements: Lowering reserve requirements frees up more funds for banks to lend, increasing the money supply and potentially stimulating economic activity.

Examples of reserve requirement policies

Reserve requirements vary across countries and are adjusted based on economic conditions and monetary policy goals:

• United States: The Federal Reserve sets reserve requirements for depository institutions. For example, as of recent policies, certain types of deposits may have a 0% reserve requirement, while others might have higher requirements.
• European Union: The European Central Bank (ECB) sets reserve requirements for euro area banks, which are typically lower than those in the U.S.
• Emerging economies: Central banks in emerging markets may use higher reserve requirements to control inflation and manage currency stability.

Understanding reserve requirements is essential for comprehending how central banks regulate the banking system and manage the economy.

By setting and adjusting these requirements, central banks can influence lending practices, money supply, and overall economic stability.