# Understanding Reserve Requirements: Definitions, History, and Impact

## What Are Reserve Requirements?

Reserve requirements mandate the cash a bank must hold to cover customer deposits, set by the Federal Reserve, and impact monetary policy significantly. These requirements were set to 0% in March 2020 to boost economic activity during COVID-19. Learn more about their function, benefits, and historical context in safeguarding banking operations.

### Key Takeaways

*   Reserve requirements dictate the amount of cash banks must hold as reserves against customer deposits and are a key tool of monetary policy.
*   The Federal Reserve has set reserve requirements to zero since March 26, 2020, to enhance liquidity during the COVID-19 pandemic.
*   Reserve requirements help manage the money supply and can influence interest rates; lower requirements typically promote more lending and lower rates.
*   Historically, reserve requirements were enforced to ensure the safe exchange of banknotes and were significantly reduced with the creation of the Federal Reserve in 1913.
*   Countries like Canada and the UK rely on capital requirements instead of reserve requirements to maintain financial stability.

## How Reserve Requirements Impact Banking

Banks loan funds to customers based on a fraction of the cash they have on hand. The government makes one requirement of them in exchange for this ability: [keep a certain amount of deposits on hand](https://www.investopedia.com/ask/answers/070815/how-must-banks-use-deposit-multiplier-when-calculating-their-reserves.asp) to cover possible withdrawals. This amount is called the reserve requirement, and it is the percentage that banks must keep in reserve and are not allowed to lend.

If a bank doesn't have enough cash to meet the reserve requirement, it borrows from other banks or from the Fed's discount window. The interest banks charge each other to borrow is called the [federal funds rate](https://www.investopedia.com/terms/f/federalfundsrate.asp), and it's the basis for many other interest rates in the economy.

The Federal Reserve's Board of Governors sets the requirement as well as the interest rate banks get paid on [excess reserves](https://www.investopedia.com/terms/e/excess_reserves.asp). The Financial Services Regulatory Relief Act of 2006 gave the Federal Reserve the right to pay interest on excess reserves. The effective date on which banks started getting paid interest was Oct. 1, 2011. This rate of interest is referred to as the interest rate on excess reserves and serves as a proxy for the federal funds rate.

The reserve requirement is another tool that the Fed has at its disposal to control liquidity in the financial system. By reducing the reserve requirement, the Fed is executing an expansionary [monetary policy](https://www.investopedia.com/terms/m/monetarypolicy.asp), and conversely, when it raises the requirement, it's exercising a contractionary monetary policy. This latter action cuts liquidity and causes a cool down in the economy.

In other words, when the Fed raises reserve requirements, banks have less to lend out to consumers and businesses. That in turn raises interest rates. When the Fed drops reserve requirements, the opposite happens: Interest rates fall.

## The Evolution of Reserve Requirements

The practice of holding reserves started with the first [commercial banks](https://www.investopedia.com/terms/c/commercialbank.asp) during the early 19th century. Each bank used its own currency, accepted only within its operational region. Exchanging this currency was costly and risky due to limited information about other banks.

To overcome this problem, banks in New York and New Jersey arranged for voluntary redemption at each other's branches on the condition that the issuing bank and redeeming bank both maintained an agreed-upon deposit of gold or its equivalent. Subsequently, the [National Bank Act of 1863](https://www.investopedia.com/articles/investing/011916/brief-history-us-banking-regulation.asp) imposed 25% reserve requirements for banks under its charge. A 1865 state banknote tax helped national banknotes replace other currencies.

The creation of the Federal Reserve and its constituent banks in 1913, as a [lender of last resort](https://www.investopedia.com/terms/l/lenderoflastresort.asp), further eliminated the risks and costs associated with maintaining reserves and pared down reserve requirements from their earlier high levels. In 1917, reserve requirements for three bank types were set at 13%, 10%, and 7%.

In response to the COVID-19 pandemic, the Federal Reserve reduced the reserve requirement ratio to zero across all deposit tiers, effective March 26, 2020. The aim of this reduction was to jump-start the economy by allowing banks to use additional liquidity to lend to individuals and businesses.

### Dec. 23, 1913

The day President Woodrow Wilson signed the Federal Reserve Act into law, thus creating the Federal Reserve.

## Comparing Reserve and Capital Requirements

Some countries don't have reserve requirements. These countries include Canada, the United Kingdom, New Zealand, Australia, and Sweden. Instead, some of these countries must adhere to capital requirements, which is the amount of equity a bank or financial institution must hold as required by its [financial regulator](https://www.investopedia.com/articles/economics/09/financial-regulatory-body.asp). 

Reserve requirements refer to the amount of liquid assets a bank must hold. These funds are intended to protect the institution from runs on deposits. A financial institution can hold additional funds above the required amount—known as [free reserves](https://www.investopedia.com/terms/f/free-reserves.asp). Capital requirements are meant to absorb losses on loans and other investments.

## Example of Reserve Requirements

As an example, assume a bank has $200 million in deposits and is required to hold 10%. The bank is now allowed to lend out $180 million, which drastically decreases [bank credit](https://www.investopedia.com/terms/b/bank-credit.asp)—the amount of money the loans the bank can make to customers.

In addition to providing a buffer against [bank runs](https://www.investopedia.com/terms/b/bankrun.asp) and a layer of [liquidity](https://www.investopedia.com/terms/l/liquidity.asp), reserve requirements 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 of bank credit and lowers rates.

## Who Sets the Reserve Requirements?

In the United States, the Federal Reserve Board sets the reserve requirements. The Federal Reserve Board receives its authority to set reserve requirements from the Federal Reserve Act. The Board establishes reserve requirements as a way to carry out a monetary policy on deposits and other liabilities of [depository](https://www.investopedia.com/terms/d/depository.asp) institutions.

## What Does a Lower Reserve Requirement Mean?

A lower reserve requirement means the Federal Reserve is pursuing an [expansionary monetary policy](https://www.investopedia.com/ask/answers/040115/what-are-some-examples-expansionary-monetary-policy.asp). The lower reserve requirement means banks do not need to keep as much cash on hand. This gives them more money for consumer and business loans.

## What Does a Higher Reserve Requirement Mean?

A higher reserve requirement means the Federal Reserve is pursuing a [contractionary monetary policy](https://www.investopedia.com/terms/c/contractionary-policy.asp). If banks have a higher reserve requirement, there will be less money available to lend to consumers and businesses. However, this money will then provide the banks with a level of protection against possible bank failure should there be an economic downturn or a run on the bank.

## The Bottom Line

Reserve requirements dictate the amount of cash that banks must hold to meet sudden withdrawals, and they serve as a crucial monetary policy tool for the Federal Reserve. Historically significant, these requirements have shifted over time, most notably being set at 0% during the COVID-19 pandemic (and after) to enhance liquidity.

Adjustments to reserve requirements can influence the economy by affecting the amount of money banks can lend, thereby impacting interest rates. Lower requirements promote loan availability and stimulate economic growth, whereas higher requirements restrict lending and can cool down the economy.

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