What are Reserve Requirements?
Reserve requirements are Federal Reserve rules that require banks and other financial institutions to keep a strict percentage of their deposits on reserve at a Federal Reserve bank. The Federal Reserve determines the appropriate percentage.
How Do Reserve Requirements Work?
For example, Bank XYZ has $400 million in deposits. The Federal Reserve’s reserve requirement is 10%, which means that Bank XYZ must keep at least $40 million in an account at a Federal Reserve bank and may not use that cash for lending or any other purpose.
The Federal Reserve is the central bank of the United States. It is a bank for banks. Its several branches around the U.S. hold deposits for and lend to banks. As a means of ensuring the safety of nation's financial institutions, the Federal Reserve sets reserve requirements so that banks always have some money on hand to prevent a run (a mass withdrawal of deposits so large that the bank actually runs out of cash, panicking the rest of the depositors). If a bank is unable to meet its reserve requirement, it can borrow from the Federal Reserve to meet the requirement.
Why Do Reserve Requirements Matter?
Reserve requirements are a key component of monetary policy. The Federal Reserve can lower the reserve requirement, for example, in order to enact expansionary monetary policy and encourage economic growth. The reduction makes banks free to lend more of their deposits to other bank customers and earn interest. These customers in turn deposit the loan proceeds in their own bank accounts, and the process continues indefinitely. This increase in the supply of available funds lowers the price of those funds (i.e., the lending rate), making debt cheaper and more enticing to borrowers.
If the Federal Reserve increases the reserve requirement (which leaves less of a bank's deposits available for lending), the reverse happens and the Federal Reserve can slow down the economy.