Reserve Requirements

A reserve requirement is a regulatory rule mandating that banks hold a minimum fraction of their deposits as cash or as balances at the central bank. For decades, reserve requirements were a primary tool of monetary policy: lowering the requirement let banks lend more, easing credit; raising it forced them to hold more cash idle, tightening credit. Today, the tool is used sparingly, as most central banks prefer interest rates and asset purchases.

How reserve requirements work

A bank takes deposits from customers—say, $100 million. A reserve requirement of 10% means the bank must hold $10 million in cash or in a reserve account at the central bank. The remaining $90 million can be lent to borrowers—funding mortgages, business loans, auto loans, and other credit.

The reserve requirement acts as a brake on lending. The higher the requirement, the less the bank can lend for a given deposit base. If the central bank raises the requirement from 10% to 15%, the bank must suddenly hold more cash idle, and it must either call in loans (difficult) or stop originating new ones until old loans are paid down. Either way, the supply of credit shrinks.

Conversely, lowering the requirement from 10% to 5% allows the bank to lend more against the same deposits. The supply of credit expands.

Reserve requirements and the money multiplier

Reserve requirements are intimately connected to the money multiplier. In a system with a 10% reserve requirement, each dollar of central-bank money (the monetary base) can theoretically support $10 in deposits, because each bank lends 90% of deposits to borrowers, who deposit those funds in another bank, which lends 90% of that, and so on.

Changing the reserve requirement changes the multiplier and therefore the total money supply that the monetary base can support. Lowering the requirement increases the multiplier and expands the potential money supply. Raising it shrinks the multiplier and contracts potential money supply.

When reserve requirements were the main tool

In the early decades of central banking, before sophisticated asset-purchase programs existed, reserve requirements were the primary tool of monetary policy. A central bank wanting to ease would lower the requirement; wanting to tighten would raise it. This was simple and powerful—no need to buy or sell securities in the market. Just change the rule, and the entire financial system adjusted.

The Federal Reserve used reserve requirement changes frequently through the 20th century. In 1992, after the savings-and-loan crisis and in response to weak growth, the Fed lowered the requirement repeatedly. The move injected massive liquidity into the financial system and helped support the economy.

Why central banks abandoned reserve requirements

Over time, central banks moved away from changing reserve requirements as a policy tool. Several reasons:

1. Unpredictability. Unlike interest rates or asset purchases, the effect of a reserve-requirement change on the broad money supply is hard to predict. Banks might hoard excess reserves rather than lend them.
2. Blunt instrument. Changing the requirement is a crude tool that affects all banks equally, regardless of their situation. Interest rates and asset purchases offer more finesse.
3. Financial-stability concerns. Raising reserve requirements can be destabilizing, forcing banks to shrink lending suddenly.
4. Modern alternatives. Interest-on-reserves and open-market operations do the same job more flexibly.

The Federal Reserve’s last major use of reserve-requirement policy was the series of reductions in 1992 mentioned above. By the 21st century, the tool had become vestigial. In March 2020, with the COVID-19 pandemic creating chaos, the Fed abolished the reserve requirement entirely, reducing it to zero. The message was clear: this tool no longer mattered for policy.

Reserve requirements today

Most central banks still maintain some form of reserve requirement, though often at low levels and with exemptions. The European Central Bank, for example, requires a 2% reserve ratio on deposits. Many developing-world central banks use higher requirements—as both a policy tool and a financial-stability measure.

The US stands alone: since 2020, there is no reserve requirement. This reflects a shift in how the Fed conducts policy. The modern framework relies on interest-on-reserves to steer bank behavior and the federal funds rate.

See also