How do bank reserve requirements work, and why do they matter?

The Federal Reserve, the central bank of the United States, imposes bank reserve requirements to regulate the economy and reduce the risk of bank runs. These reserve requirements may change with current economic conditions.

Read on to learn more about how reserve requirements work and why they are so important.

Read more: What is the Federal Reserve?

Bank reserve requirements – the amount of money that a financial institution must hold in its own vaults or with a central bank – exist to ensure that banks have enough money to handle their obligations and withdrawals from the account of the customers. Also known as fractional reserve banking, these requirements play a critical role in the economy:

• Economic stability: To control how much money a bank can lend, central banks can use the reserve requirement as a tool to manage lending and curb inflation.

• Consumer protection and trust: The establishment of bank reserve requirements ensures that financial institutions can meet customer demands, and customers have more peace of mind that their money is safe and accessible.

• Crisis prevention: Reserves also provide banks with a financial safety net, helping banks stay afloat during economic downturns.

Most countries have bank reserve requirements, but the exact requirement varies by country. It is usually defined as a percentage of a bank’s deposits. For example, if the reserve requirement is 5% and a bank has $1 million in deposits, it would need to keep at least $50,000 in cash at all times.

Banks are allowed to use their remaining deposits to make loans, invest and perform other income-generating activities.

Reserve requirements and excess reserves

Bank reserves are classified as required reserves or excess reserves.

• Mandatory reservations: As the name implies, required reserves are how much banks are required to keep on hand by the government and regulatory authorities.

• Excess Reserves: This refers to the amount of money a bank holds in reserve above the required amount set by the government and regulatory agencies. Some banks opt to hold larger reserves as protection against market conditions, while others maintain minimum reserves to maximize their ability to issue loans.

Read more: What is fractional reserve banking?

In the United States, reserve requirements apply to banks and credit unions, although the requirement may vary by bank size.

The government instituted bank reserve requirements in 1863 as part of the National Bank Act. At that time, banks were required to hold 25% in reserves. However, reserve requirements have evolved over time. In 2020, the Board of Governors of the Federal Reserve announced that it reduced the reserve requirement to 0%. The goal of this change was to provide banks with more money to issue loans and strengthen the economy.

Even so, this does not mean that banks are currently operating with zero cash on hand. Financial institutions generally maintain reserves to manage operational requirements and regulatory compliance with other frameworks such as liquidity coverage ratios.

If a bank does not have enough money in its reserves, it borrows from other banks or from the Fed. The interest rate that banks pay each other for these short-term loans is called the federal funds rate, which serves as the foundation for many other interest rates in the economy.

Read more: Federal funds rate: what it is and how it affects you

Thanks to the reserve requirement, you can withdraw money with confidence. For example, if you need to withdraw a relatively large sum, you can visit a local branch, complete the withdrawal and receive the money immediately; you don’t have to worry about the bank manager informing you that you have insufficient funds.

Bank reserve requirements, in combination with FDIC insurance, protect you from bank failures. Bank reserves make it less likely that a bank will become insolvent, and the FDIC protects your deposits up to $250,000 (per depositor, per institution, per property category) in the event that the financial institution fails.

However, bank reserve requirements can affect you in other ways, including the rates you pay on auto, personal or home loans. With lower bank reserves, banks have a greater ability to issue loans, so they can lower rates. When the bank reserve requirement increases, banks have less funds available, so they tighten lending requirements and raise interest rates.

Read more: Can credit unions fail?

Bank reserve requirements are a foundation of strong financial systems, and play a major role in the US economy. These requirements ensure that you have ready access to your money when you need it, and prevent bank runs and failures.

Choosing a bank that is backed by the FDIC and governed by federal regulatory agencies provides a greater level of stability so you can manage your money with confidence.