Understanding Reserve Requirements

Key takeaways
* Reserve requirements are the portion of customer deposits banks must keep as liquid reserves and not lend out.
* The Federal Reserve set U.S. reserve requirements to 0% on March 26, 2020 to boost liquidity during the COVID‑19 shock.
* Lower reserve requirements free up funds for lending and support expansionary monetary policy; higher requirements reduce lending and have a contractionary effect.
* Some countries rely on capital requirements instead of formal reserve ratios to ensure financial stability.

What reserve requirements are

Reserve requirements (or reserve ratios) specify the percentage of deposit liabilities that depository institutions must hold as cash in their vaults or as balances at the central bank. These reserves protect against sudden withdrawals and are a direct tool the central bank can use to influence liquidity and credit conditions.

How reserve requirements work

• Banks receive customer deposits and may lend a portion of those deposits while keeping the required percentage on hand as reserves.
• If a bank falls short of its reserve requirement, it can borrow from other banks in the overnight market or access the central bank’s discount window.
• The overnight interbank borrowing rate is known as the federal funds rate in the U.S.; it serves as a benchmark for many other interest rates.
• The Fed also pays interest on excess reserves (IOER), providing a floor for short‑term interest rates and influencing banks’ incentives to lend or hold reserves.

Impact on banking and monetary policy

• Expansionary policy: Lowering reserve requirements increases banks’ lendable funds, tends to reduce interest rates, and supports economic activity.
• Contractionary policy: Raising reserve requirements reduces banks’ capacity to lend, tends to raise interest rates, and can cool economic activity.
• Reserve requirements are one of several monetary tools (alongside open market operations, policy rates, and capital rules) used to control money supply and financial stability.

History and evolution

• The practice of holding reserves dates to early commercial banking in the 19th century, when banks used reserves to facilitate redemption of banknotes and reduce settlement risk.
• U.S. reserve rules have changed over time; the National Bank Act (1863) and the creation of the Federal Reserve (1913) shaped modern reserve and liquidity practices.
• In response to the COVID‑19 pandemic, the Federal Reserve reduced required reserve ratios to 0% for all deposit tiers on March 26, 2020, allowing banks to use more liquidity for lending.
• Since 2011 the Fed has paid interest on reserve balances, adding an operational tool to influence short‑term rates.

Reserve requirements vs. capital requirements

• Reserve requirements: Liquid assets that must be held to meet depositor withdrawals and support daily liquidity.
• Capital requirements: Equity cushions required to absorb losses and protect depositors and the financial system from insolvency.
• Several countries (for example, Canada, the U.K., Australia, Sweden, and New Zealand) rely more on capital and liquidity regulation than on formal reserve ratios.

Simple example

If a bank has $200 million in deposits and a 10% reserve requirement, it must hold $20 million in reserves and can lend $180 million. Lowering the requirement increases the lendable amount; raising it reduces lending capacity.

Who sets reserve requirements (U.S.)

The Federal Reserve Board sets reserve requirements in the United States under authority granted by law. The Fed uses this power, alongside other instruments, to implement monetary policy affecting deposits and other liabilities of depository institutions.

What lower or higher reserve requirements mean

• Lower requirement = expansionary stance: more funds available for loans, potentially lower interest rates, stimulus to economic activity.
• Higher requirement = contractionary stance: less lending capacity, potentially higher interest rates, increased liquidity buffers to reduce risk of bank runs.

Conclusion

Reserve requirements are a traditional monetary policy tool that directly affect banks’ liquidity and lending capacity. While their practical use has evolved—many jurisdictions emphasize capital and broader liquidity regulation—the ratio remains an important mechanism for influencing money supply, interest rates, and financial stability.