Reserve Requirements

What are 'Reserve Requirements'

Reserve requirements are requirements regarding the amount of cash a bank must hold in reserve against deposits made by customers. This money must be in the bank's vaults or at the closest Federal Reserve bank. Set by the Fed's board of governors, reserve requirements are one of the three main tools of monetary policy — the other two tools are open market operations and the discount rate.

BREAKING DOWN 'Reserve Requirements'

Banks loan funds out to customers based on a fraction of the cash they actually have on hand. The government makes one requirement of them in exchange for this ability: keep a certain amount of deposits on hand to cover possible withdrawals. This amount is called the reserve requirement, and it is the rate that banks must keep in the reserve. The Federal Reserve's Board of Governors sets the requirement as well as the interest rate banks get paid on excess reserves. The Financial Services Regulatory Relief Act of 2006 gave the Federal Reserve the right to pay interest on excess reserves. The effective date in which banks started getting paid interest was Oct. 1, 2008. This rate of interest is referred to as the interest rate on excess reserves and serves as a proxy for the federal funds rate.

Requirement Thresholds

The Garn-St. Germain Act of 1982 allows some banks to be exempt from the requirement rule. Currently the threshold for exemptions is set at $2 million, which means the first $2 million of reservable liabilities are exempt from reserve requirement rules. The threshold is adjusted each year as set forward by a calculation provided in the act. As of Jan. 21, 2016, banks with deposits less than $15.2 million have no reserve requirement. Banks with between $15.2 million and $110.2 million in deposits have a reserve requirement of 3%, and banks with over $110.2 million in deposits have a reserve requirement of 10%.

Reserve Requirement Example

As an example, assume a bank had $200 million in deposits and is required to hold 10%. The bank is now allowed to lend out $2 billion, which drastically increases bank credit. In addition to providing a buffer against bank runs and a layer of liquidity, reserve retirements are also used as a monetary tool by the Federal Reserve. By increasing the reserve requirement the Federal Reserve is essentially taking money out of the money supply and increasing the cost of credit. Lowering the reserve requirement pumps money into the economy by giving banks excess reserves, which promotes the expansion for bank credit and lowers rates.

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