What Is the Required Reserve Ratio for Banks?
Understand bank reserve ratios, their historical role in banking, and how central banks now influence monetary policy.
Understanding Bank Reserve Requirements
Bank reserve requirements historically referred to the portion of customer deposits that banks were legally mandated to hold, rather than lend out. These requirements ensured banks maintained a certain level of liquid assets to meet potential withdrawals and financial obligations. Reserves typically included cash in the bank’s vaults and funds kept in the bank’s account at the central bank.
The foundational purpose of these requirements was to ensure bank liquidity, preventing bank runs where many depositors withdraw funds simultaneously. They also served as a tool for influencing the money supply. Required reserves were calculated by multiplying a bank’s total deposits by the specified reserve ratio. For instance, if a bank holds $500 million in deposits and the reserve ratio is 10%, it would be required to hold $50 million in reserves.
The Central Bank’s Role
In the United States, the Federal Reserve traditionally set and adjusted reserve requirements for depository institutions. This power stemmed from the Federal Reserve Act, which allowed the Board of Governors to establish requirements on various liabilities. Central banks used reserve requirements as a tool of monetary policy to influence economic activity.
Raising the reserve ratio reduced the money banks had available to lend, contracting the money supply and potentially increasing interest rates. Conversely, lowering the ratio freed up more funds for lending, expanding the money supply and potentially lowering interest rates. This mechanism influenced credit conditions and the overall economy. Central banks considered changes to the reserve ratio carefully, as abrupt adjustments could create liquidity challenges for banks.
Reserve Requirements Today
As of March 26, 2020, the Federal Reserve reduced the reserve requirement ratio for all depository institutions to zero percent. This means banks in the United States are no longer legally required to hold a specific fraction of their deposits as reserves. This decision was made because the banking system had already shifted to an “ample reserves” regime. In this framework, banks naturally hold substantial reserves, rendering formal requirements unnecessary for liquidity management or monetary policy control.
Under the ample reserves framework, the Federal Reserve primarily influences monetary policy through administered interest rates, rather than by directly managing reserve quantity. A primary tool is the interest on reserve balances (IORB) rate, which the Fed pays on reserves banks hold at the Federal Reserve. Adjusting the IORB rate influences the federal funds rate, the interest rate at which banks lend reserves to each other overnight. An increase in the IORB rate puts upward pressure on short-term interest rates, while a decrease lowers them.
Open market operations remain a tool, though their role has evolved. Instead of adjusting reserve supply to meet a target federal funds rate, they now maintain an ample supply of reserves in the banking system. The Fed buys or sells government securities to inject or withdraw money, increasing or decreasing reserves. This ensures sufficient reserves for interest rate control through administered rates like the IORB. Banks still manage liquidity prudently, but lending decisions are now influenced by capital requirements, market demand for loans, and internal liquidity management strategies, rather than a specific reserve ratio.