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.

RELATED TERMS
  1. Reservable Deposit

    A bank deposit subject to reserve requirements. Reserve requirements ...
  2. Bank Reserve

    Bank reserves are the currency deposits which are not lent out ...
  3. Reserve Ratio

    The portion (expressed as a percent) of depositors' balances ...
  4. Free Reserves

    A measurement of a bank's reserves that is equal to the difference ...
  5. Working Reserves

    Reserves held by banks above the required minimum level - or ...
  6. Fractional Reserve Banking

    A banking system in which only a fraction of bank deposits are ...
Related Articles
  1. Markets

    Explaining the Reserve Ratio

    Reserve ratio is the amount of cash a bank must keep in its bank vaults or deposit into a central, governing bank.
  2. Markets

    What's the Federal Funds Rate?

    The federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements.
  3. Markets

    How The U.S. Government Formulates Monetary Policy

    Learn about the tools the Fed uses to influence interest rates and general economic conditions.
  4. Markets

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  5. Markets

    What is Fractional Reserve Banking?

    Fractional reserve banking is the banking system most countries use today.
  6. Markets

    Regional Banks Give The Fed A National Perspective

    We all know that the Federal Reserve utilizes monetary policy to control the economy, but what do the 12 regional Federal Reserve Banks do?
  7. Markets

    What Do the Federal Reserve Banks Do?

    These 12 regional banks are involved with four general tasks: formulate monetary policy, supervise financial institutions, facilitate government policy and provide payment services.
  8. Markets

    How The Federal Reserve Manages Money Supply

    Find out how the Fed manages bank reserves and this contributes to a stable economy.
  9. Markets

    Explaining the Federal Discount Rate

    The federal discount rate is the rate at which eligible banks or other depository institutions can borrow funds from a Federal Reserve bank.
  10. Markets

    Explaining the Federal Reserve System

    The Federal Reserve System is the central bank of the United States. It regulates monetary policy and supervises the nation’s banking system.
RELATED FAQS
  1. How are bank reserve requirements determined and how does this affect shareholders?

    Learn how bank reserve requirements are determined and how bank reserves affect shareholders through improved bank stability ... Read Answer >>
  2. What do banks do to control the bank reserve?

    Understand what the Federal Reserve does in order to expand or contract the economy. Learn what depository institutions can ... Read Answer >>
  3. Who determines the reserve ratio?

    Understand what the Federal Reserve is and what it regulates in the U.S. economy. Learn about the reserve ratio and how the ... Read Answer >>
  4. How do central banks acquire currency reserves and how much are they required to ...

    A currency reserve is a currency that is held in large amounts by governments and other institutions as part of their foreign ... Read Answer >>
  5. Why would the Federal Reserve change the reserve ratio?

    Understand the Federal Reserve's monetary policy and the tools it uses to change that monetary policy. Learn about the reserve ... Read Answer >>
  6. What happens if the Federal Reserve lowers the reserve ratio?

    Learn about the Federal Reserve's monetary policy and the tools it uses to control it. Understand what happens if the Federal ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center