Reserve Requirements

Reserve requirements are the amount of money that commercial banks are required to hold in reserve, either in cash or in deposits.

Reserve requirements are set by the central bank and are used to control the money supply.

Central banks worldwide utilize a range of policy tools to achieve their monetary policy objectives, such as maintaining price stability, promoting economic growth, and ensuring financial stability.

One tool that central banks have used for a long time is to force financial institutions to keep a certain amount of money in reserve.

What are reserve requirements?

Reserve requirements refer to the minimum amount of funds that financial institutions, such as commercial banks, are required to hold in reserve against their deposit liabilities.

These reserves can be held either as cash in the bank’s vault or as deposits at the central bank.

Reserve requirements are typically expressed as a percentage of the bank’s total deposit liabilities and can vary depending on the type of deposit or the size of the financial institution.

What is the purpose of reserve requirements?

The main purposes of reserve requirements are:

Ensure financial stability: By requiring financial institutions to hold a certain level of reserves, central banks can help ensure that these institutions have sufficient liquidity to meet their short-term obligations, reducing the risk of bank runs and promoting overall financial stability.
Implement monetary policy: Reserve requirements can also be used as a tool for implementing monetary policy by influencing the supply of money and credit in the economy. By adjusting reserve requirements, central banks can affect the amount of funds available for lending, thus impacting interest rates and overall monetary conditions.
Facilitate the smooth functioning of the payment system: Reserve requirements help to ensure that financial institutions have sufficient funds on hand to settle interbank transactions, contributing to the smooth functioning of the payment system.

How do reserve requirements work?

Central banks typically set reserve requirements as part of their broader monetary policy framework.

They can adjust reserve requirements periodically to reflect changes in their policy stance or to respond to evolving economic conditions.

What happens when reserve requirements are raised?

When the central bank raises reserve requirements, financial institutions are required to hold a larger portion of their deposit liabilities in reserve, reducing the amount of funds available for lending. This can lead to a contraction in the supply of money and credit in the economy, potentially resulting in higher interest rates and tighter monetary conditions.

What happens when reserve requirements are lowered?

When the central bank lowers reserve requirements, financial institutions can hold a smaller portion of their deposits in reserve, increasing the amount of funds available for lending and potentially leading to an expansion in the supply of money and credit and lower interest rates.

Are reserve requirements still relevant?

Reserve requirements are a traditional tool used by central banks to promote financial stability and help with the implementation of monetary policy.

While RRR remains relevant in some jurisdictions; its importance as a monetary policy tool has diminished in several advanced economies, including the U.S. and the eurozone.

For example, in the U.S. as of March 2020, the reserve requirement for all deposit institutions was set to 0% of eligible deposits. The removal of reserve requirements followed the Federal Reserve’s shift to an “ample-reserves” system, in which the Federal Reserve Banks pay member banks interest on excess reserves held by them.

Central banks in these economies have shifted their focus to other policy tools, such as open market operations, interest on reserves, and large-scale asset purchases, to achieve their monetary policy objectives.

There are several reasons for this shift:

Greater flexibility with alternative tools: Alternative monetary policy tools, such as open market operations and interest on reserve balances, provide central banks with more flexibility and precision in controlling short-term interest rates and implementing monetary policy.
Changes in the financial system: Technological advancements and innovations in the financial system have reduced the reliance on reserve requirements as a means of ensuring financial stability and liquidity management.
Avoidance of potential disruptions: Frequent changes in reserve requirements can cause disruptions in the financial system and complicate banks’ liquidity management, leading central banks to prefer more stable and predictable policy tools.

Despite these trends, reserve requirements remain an essential policy tool for central banks in many emerging and developing economies.

The relevance of reserve requirements largely depends on the specific characteristics and needs of the financial system in each jurisdiction.

Related Terms

Scarce Reserves Regime

The scarce reserves regime refers to a monetary policy framework in which reserve balances held by banks are relatively low,.

Reserves

Reserves are funds held by banks and other depository institutions, either in the form of cash or as deposits with a central bank.

Ample Reserves Regime

The ample reserves regime refers to a framework in which the central bank ensures that there is a large amount of excess reserves in the banking system.

Interest on Reserve Balances

Interest on reserve balances refers to the interest that central banks pay to financial institutions on the funds they hold in reserve accounts.

Federal Reserve

The Federal Reserve is the central bank of the United States. The Federal Reserve often referred to as the Fed, is an independent entity that was established by Congress on December 23, 1913. Prior...