Understanding Bank Reserves: Definition, Purpose, and Impact

Key takeaways

• Bank reserves are cash holdings banks keep to meet withdrawal demands and comply with central bank rules.
• Reserves can be required (minimum mandated) or excess (held voluntarily).
• The U.S. Federal Reserve set reserve requirements to zero on March 26, 2020, but banks still follow liquidity standards such as the Basel III liquidity coverage ratio (LCR).
• After 2008 the Fed began paying interest on reserves, which changed banks’ incentives about holding excess cash.

What are bank reserves?

Bank reserves are the cash a bank holds on hand or on deposit at the central bank to meet customer withdrawals and regulatory requirements. They serve two main purposes:
* Provide liquidity to fulfill withdrawals and payments, reducing the risk of a bank run.
* Act as a tool for monetary policy when central banks adjust reserve requirements to influence lending and money supply.

Reserve requirements are typically expressed as a reserve ratio — a percentage of certain deposit types that must be held as reserves. Historically this ratio has ranged from 0% to about 10% in the U.S.

Required vs. excess reserves

• Required reserves: the minimum amount a bank must hold, determined by the central bank based on a bank’s net transaction accounts (demand deposits, certain transfer accounts, etc.).
• Excess reserves: any reserves held above the required minimum. Banks generally avoid holding large excess reserves because cash earns little or no return and can lose value to inflation. However, when central banks pay interest on reserves, holding excess reserves can become relatively attractive.

Reserves tend to fall during economic expansions (as lending increases) and rise during recessions (as lending tightens and deposits may increase).

How central banks use reserve requirements

Central banks can change reserve requirements to influence credit availability:
* Lowering the reserve ratio frees up funds for banks to lend, potentially stimulating economic activity.
* Raising the ratio reduces lending capacity, which can help cool an overheated economy.

Many advanced economies have also used other tools (open market operations, quantitative easing) alongside or instead of reserve ratios.

Historical context and evolution

Early U.S. banking lacked a consistent national system, and bank runs were common until the Federal Reserve System was created in 1913 after repeated financial panics (notably 1907). Over time the Fed’s role expanded; by the late 20th century it focused on price stability and broader monetary policy goals.

Key policy shifts:
* 2008: Following the financial crisis, the Fed began paying interest on reserve balances (effective Oct. 1, 2008), which contributed to a large increase in excess reserves.
* 2020: In response to the COVID-19 crisis, the Fed set reserve requirements to zero on March 26, 2020 — effectively removing the minimum reserve ratio as a day‑to‑day policy tool while maintaining other liquidity safeguards.

Liquidity coverage ratio (LCR) and global standards

Beyond national reserve rules, international banking standards (Basel III) require banks to meet liquidity metrics:
* The LCR requires banks to hold sufficient high-quality liquid assets to cover net cash outflows for 30 days.
These rules are intended to ensure banks can withstand short-term stress without immediate central bank borrowing, and they remain binding even when reserve ratios are low or zero.

The 2008 crisis and interest on reserves

Before 2008, reserves earned no interest. During the crisis, the Fed began paying interest on reserve balances to help control short-term rates and provide banks with a safe return. This changed behavior: banks often chose to hold newly injected cash as interest-bearing excess reserves rather than lend it out, prioritizing safety over higher-risk lending.

Practical details

• Calculation: Required reserves = total deposits subject to reserves × reserve ratio. Example: $500 million in deposits × 10% = $50 million required reserves.
• Accounting: Reserves are assets on a bank’s balance sheet.
• Where reserves are held: in vault cash at the bank, on deposit at one of the regional central bank branches, or (for smaller banks) held via correspondent relationships with larger banks. Cash movements between vaults and central banks fluctuate with seasonal demand (e.g., holidays).

Conclusion

Bank reserves are a core part of financial stability and monetary policy. While traditional reserve requirements in the U.S. are currently set to zero, modern regulatory frameworks — including interest on reserves and international liquidity standards like the LCR — continue to shape banks’ liquidity management. Understanding reserves helps explain how banks meet withdrawals, respond to policy changes, and contribute to overall economic stability.