Reserve RequirementDefined with Examples & More

Ever wonder if there’s a limit as to how much credit banks can extend?

If all the people in the US were to borrow $1 million each (assuming that they’re all eligible), will the banks be able to cater to them all?

For now, let’s say that they can.

So the banks granted a $1 million loan to each individual in the US.

The question now is, do these banks still have enough cash to cater to deposit withdrawals?

What if someone who deposited a huge amount of money were to withdraw it all?

Enter reserve requirement.

One of the purposes of a reserve requirement is to ensure the banks have enough cash on hand to cater to large withdrawals on deposits.

As bank deposits typically don’t have a term on them, they can be withdrawn at any time.

So a depositor may withdraw his/her deposit at any time.

This could be problematic if the bank does not have enough cash on hand to answer to cash withdrawals.

It may even taint its reputation.

Another thing, while loans are the main driver of a bank’s revenue, they are generally long-term – meaning that it will take time to fully collect them.

On the other hand, bank deposits can be withdrawn anytime.

In a way, a reserve requirement restricts banks from lending all of their available cash.

What is a reserve requirement?

A reserve requirement is the minimum amount of cash a bank must always have in its vault or at the closest central bank (or federal reserve bank).

The amount will depend on how much customer deposit the bank holds.

It is one of three main tools of monetary policy, the other two being open market operations and the discount rate.

It is regulated by a country’s central bank.

In the US, it’s the Federal Reserve’s Board of Governors that regulates bank reserve requirements.

For example, a bank has $300 million in deposits so it must have a reserve of 8% of total deposits to adhere to reserve requirements.

That means that the bank must have at least $24 million cash in its vault or at the closest federal reserve bank at all times.

Normally, this would be enough to cater to large withdrawals of deposits.

The bank is then free to lend the remaining $276 million of its deposits.

Banks still run the risk of having their clients collectively withdraw their deposits that are in excess of the banks’ reserves.

A reserve requirement only accounts for normal circumstances.

Under normal circumstances, banks expect that only a portion of deposits will be withdrawn at the same time.

In the event that withdrawals do exceed a bank’s reserves, the bank may borrow funds through the interbank lending market (with a surplus).

As a last resort, the bank may loan from the central bank (the Federal Reserve in the US).

A bank is free to maintain a reserve of more than the required amount.

Reserve requirements are just the minimum after all.

We refer to these excess amounts as excess reserves.

Starting October 1, 2011 banks were paid interest for excess reserves.

Who relegates the reserve requirement?

Generally, it is the country’s central bank that regulates the reserve requirement.

In the US, it’s the Federal Reserve’s Board of Governors that relegates the reserve requirement.

The Federal Reserve Board was granted this authority by the Federal Reserve Act.

The reserve requirement also serves as a tool of monetary policy.

Some countries don’t require banks to have a reserve.

Instead, these countries require banks to adhere to certain capital requirements.

These countries include Australia, Canada, Hong Kong, New Zealand, Sweden, and the United Kingdom.

Reserve requirement as a tool of monetary policy

The reserve requirement also serves as a tool of monetary policy.

The Federal Reserve Board can control liquidity in the financial system by modifying reserve requirements.

For example, the Federal Reserve Board may lower the reserve requirement to allow banks to lend more money.

We refer to this action as an expansionary monetary policy.

By allowing banks to lend more, the money available in the market increases.

Businesses or individuals may then avail of more loans, which then livens up the economy.

The Federal Reserve Board may also decide to raise the reserve requirement.

This action is what refer to as a contractionary monetary policy.

Raising the reserve requirement reduces the amount of money the banks are allowed to loan.

This also takes away money from circulation.

This reduces liquidity and allows the economy to take a break or cool down.

That said, the Federal Reserve Board cannot just raise the reserve requirement without careful consideration.

An abrupt and unwarranted change will cause liquidity problems for banks that have low excess reserves.

Even more so for banks that don’t have excess reserves at all.

With that said, regulatory boards do not usually alter reserve requirements to implement a country’s monetary policy.

This is because of the potential short-term disruptive effect on financial markets.

In the US, the Federal Reserve Board recently changed the policy on reserve requirements as a response to the COVID-19 pandemic.

As of March 2020, the reserve requirement for all deposit institutions was set to 0%.

Banks no longer have to maintain reserves as a result.

This change in the reserve requirement aims to rejuvenate the US economy from the effects of COVID-19.

Reserve requirements and interest rates

Another effect of changes in the reserve requirements is the change in market interest rates.

If the reserve requirement is raised, banks will have less money available to lend.

As such, banks will charge more to lend money.

This will increase the prevailing interest rate.

On the other hand, when the reserve requirement is reduced, banks will be able to lend more money.

Since there is an increase in money available for loans, banks will charge less.

This will decrease the prevailing interest rate.

But as I’ve already said, the Federal Reserves Board rarely changes the reserve requirement.

Instead, it can look for other avenues to control the interest rate.

For example, it may set the target for fed funds as high.

This will increase the cost of lending for inter-bank loans.

As such, it practically has the same effect as raising the reserve requirement.

The fed funds may also be set low to increase liquidity.

This effectively lowers the cost of inter-bank lending.

As such, it practically has the same effect as reducing the reserve requirement.