What Are Reserve Requirements?

What Are Reserve Requirements?

You need to know that reserve requirements are rules set by the Federal Reserve mandating the cash banks must hold to cover customer deposits, and they play a big role in monetary policy. I’ll tell you directly: these were dropped to 0% in March 2020 to stimulate the economy during the COVID-19 crisis. Stick with me as I explain their function, benefits, and historical role in protecting banking operations.

How Reserve Requirements Impact Banking

Banks lend out money based on a portion of their available cash. In return for this privilege, the government requires them to keep a specific amount of deposits in reserve for potential withdrawals. This is the reserve requirement—the percentage banks must hold back and can't lend out.

If a bank falls short on reserves, it borrows from other banks or the Fed's discount window. The rate banks charge each other for these loans is the federal funds rate, which underpins many other interest rates in the economy.

The Federal Reserve's Board of Governors sets the reserve requirement and the interest paid on excess reserves. The Financial Services Regulatory Relief Act of 2006 allowed the Fed to pay interest on excess reserves, effective October 1, 2011. This interest rate on excess reserves acts as a stand-in for the federal funds rate.

Reserve requirements are one of the Fed's tools for managing liquidity in the financial system. Lowering them implements expansionary monetary policy, while raising them enacts contractionary policy, reducing liquidity and cooling the economy.

Put simply, when the Fed increases reserve requirements, banks have less money to lend to consumers and businesses, which drives up interest rates. When it decreases them, interest rates drop as lending increases.

The Evolution of Reserve Requirements

Reserve holding began with early 19th-century commercial banks. Each issued its own currency, valid only in its area, making exchanges expensive and risky due to limited bank information.

To fix this, banks in New York and New Jersey agreed to redeem each other's notes if both maintained gold deposits or equivalents. Then, the National Bank Act of 1863 set 25% reserve requirements for its banks, and a 1865 tax on state banknotes helped national notes dominate.

The Federal Reserve's creation in 1913 as a lender of last resort reduced reserve risks and costs, cutting requirements from high levels. By 1917, requirements were 13%, 10%, and 7% for three bank categories.

In response to COVID-19, the Federal Reserve set the reserve ratio to zero for all deposit tiers starting March 26, 2020, to boost the economy by freeing up liquidity for loans to people and businesses.

December 23, 1913, is the date President Woodrow Wilson signed the Federal Reserve Act, establishing the Federal Reserve.

Comparing Reserve and Capital Requirements

Some countries skip reserve requirements altogether, including Canada, the United Kingdom, New Zealand, Australia, and Sweden. They rely on capital requirements instead—the equity a bank must hold as mandated by its regulator.

Reserve requirements focus on liquid assets banks must keep to guard against deposit runs; banks can hold extra as free reserves. Capital requirements, however, absorb losses from loans and investments.

Example of Reserve Requirements

Take a bank with $200 million in deposits required to hold 10%. It can lend out $180 million, sharply reducing available bank credit for customer loans.

Beyond buffering against runs and providing liquidity, reserve requirements are a Federal Reserve monetary tool. Raising them removes money from circulation and increases credit costs; lowering them adds reserves, expands credit, and cuts rates.

Who Sets the Reserve Requirements?

In the U.S., the Federal Reserve Board sets reserve requirements under authority from the Federal Reserve Act. It uses them to implement monetary policy on deposits and liabilities of depository institutions.

What Does a Lower Reserve Requirement Mean?

A lower reserve requirement signals the Federal Reserve's expansionary monetary policy. Banks hold less cash, freeing up more for consumer and business loans.

What Does a Higher Reserve Requirement Mean?

A higher reserve requirement indicates contractionary monetary policy from the Federal Reserve. Banks have less to lend, but it protects against failures during downturns or runs.

The Bottom Line

Reserve requirements specify the cash banks must hold for sudden withdrawals and are a vital Federal Reserve monetary policy tool. They've changed over time, notably to 0% during and after COVID-19 to boost liquidity.

Adjusting these requirements affects how much banks can lend, influencing interest rates. Lower requirements increase loan availability and economic growth; higher ones limit lending to cool the economy.