| Updated: October 23, 2025Reserve requirements of banks
You will learn about the following concepts
- Changing the reserve requirements – how does it work?
- Possible effects
- Federal Reserve Banks’ practice
- and more…
As we’ve already mentioned, there are three ways in which central banks can control the money supply in an economy in an attempt to provide price stability, maintain stable employment and foster overall robust economic growth. Central banks can influence the amount of money in circulation by raising or lowering interest rates, changing banks’ reserve requirements or conducting open-market operations. Some of these methods are favoured more than others because they are considered more effective, but all of them are used around the world.
Typically, central banks refrain from intervening in the market unless a major imbalance occurs and the value of the local currency needs to be protected (or vice versa). This is because each intervention runs counter to free-market principles, according to which a currency’s value should be determined purely by supply and demand.
Moreover, given the role and status of central banks, every decision they make has a broad-ranging impact on all participants in the economy, especially if it is unexpected and catches the markets off-guard. As mentioned earlier, some of the methods used to control the money supply are less favoured because they are less efficient and can cause strong short-term disruptions; the reserve requirement is one such tool.
- Trade Forex
- Trade Crypto
- Trade Stocks
- Regulation: NFA
- Leverage: Day Margin
- Min Deposit: $100
Reserve requirements of banks
The reserve requirement is a tool used by most, though not all, central banks, which obliges commercial banks under their authority to hold a specific amount of their customers’ deposits and notes as a reserve. Those reserves must be physically stored as cash in the bank’s vault or held as a deposit with the central bank.
The portion of depositors’ balances that banks must maintain as reserves is referred to as the “reserve ratio”, which represents the percentage of clients’ deposits a bank must hold as required reserves. Banks can also hold excess reserves, which are amounts of cash stored above the minimum requirement.
Example
Bank ABC has $100 million in deposits, with the central bank having previously set the minimum reserve requirement at 10%. This means that, at any given time, ABC must have at least $10 million in cash stored in its vault or deposited with the central bank and cannot use this money for lending or any other purpose. If it chooses, ABC can hold a larger amount of money that exceeds the minimum requirement—the so-called excess reserves. In our example, Bank ABC could keep $15 million as reserves, of which $10 million is the required minimum and cannot be utilised in any way, while the remaining $5 million can be used at its discretion.
How does it work
But how does changing the amount of money banks must store impact the currency’s value and, by extension, the broader economy? The reserve requirement affects the country’s interest rates by reducing or increasing the amount of money available for banks to lend to their clients.
When central banks decrease the reserve-requirement ratios, they free up capital that was previously held as reserves and induce an expansion of bank credit.
When central banks increase the ratios, they force commercial banks to lock in capital that otherwise could have been lent out, effectively reducing the amount of money flowing through the economy.
Similar effect
The minimum reserve requirement is significant because, by altering the money supply, it affects the value of the local currency and ultimately has the same effect as a change in the interest rate.
If a commercial bank is required to keep a larger amount of money as reserves, effectively reducing the capital it can lend, banks will charge their borrowers more—that is, interest rates will rise. Although this makes access to credit more expensive, thereby reducing credit growth and generally slowing economic activity, operating at higher rates benefits savers because they earn a higher return on the money they have deposited in the banks. In most cases, this raises the value of the local currency because foreign investors seek to benefit from the higher return; to invest, they need to buy the local currency, thus increasing demand for it.
The opposite also holds true. If the central bank reduces the amount of money banks must hold or deposit with it, liquidity is freed up, boosting credit activity and driving interest rates down. This eventually curbs the flow of foreign investment and reduces demand for the local currency.
Negative effects
Typically, however, central banks avoid tampering with the amount of reserves banks must keep, as such a shift can dramatically change their ability to lend money in either direction. An increase in the minimum reserve requirement could have an exceedingly harmful effect on smaller institutions and on those with low excess reserves.
Banks follow the maxim that “sleeping money doesn’t do you any good”, and, because they profit by lending out as much money as possible and earning interest, it is quite normal for them to hold only a very small portion of their total assets in cash. This means that, if a central bank decides to raise its minimum reserve requirement, many commercial banks that have not anticipated such an intervention and have not prepared for it will experience major difficulties complying with the obligation in the short term. This would introduce stress to the country’s banking system since, as we know, all banks are linked together through the interbank market, where they exchange liquidity on a daily basis.
Meanwhile, altering the reserve requirements can also lead to changes in pricing schedules for a number of bank services, as some bank fees and credits are based on reserve requirements.
Having noted these negative aspects of using the minimum reserve requirement as a tool of monetary policy, most Western central banks rarely alter the reserve ratios and generally prefer to use open-market operations, which will be explained in detail in the next chapter.
Federal Reserve
In the United States, the Federal Reserve, whose decisions carry dominant significance for the financial markets, has set three levels of reserve requirements based on the dollar amount of net transaction accounts held with depository institutions. They are set as follows:
– institutions with net transaction accounts totalling less than $12.4 million are required to keep 0% as reserves; this exemption amount will be raised to $13.3 million as of 23 January 2014
– institutions with total net transaction accounts amounting to between $12.4 million and $79.5 million must keep reserves of 3%; the low-reserve tranche is due to be raised to between $13.3 million and $89.0 million as of 23 January 2014
– institutions holding more than $79.5 million in net transaction accounts are obliged to maintain a liquidity ratio of 10%; the lower limit will be lifted to $89.0 million as of 23 January 2014.
When you look at the changes the Federal Reserve has introduced to the exemption amount and low-reserve tranche over the past 25 years, you will notice that central bankers steadily increased them at a minor and gradual pace in the years before the Lehman Brothers collapse in order to avoid short-term disruptions. During those 20 years, the altered ratios had an overall mixed effect on the total amount of reserves held in the system.
Since the bankruptcy of Lehman Brothers, which marked the beginning of the late-2000s global financial crisis, the Federal Reserve has been lifting both the exemption and low-reserve tranche amounts to a greater degree. These increases have ultimately reduced the overall amount of reserves required in the system by shifting the burden from smaller onto larger institutions.