Reserve Requirements

How Do Reserve Requirements Work in Economics?

Financial institutions such as commercial banks produce income by taking in deposits from savers and lending that money out to borrowers in exchange for interest payments.

Suppose that these banks did not also keep a portion of their deposits on hand for safekeeping.

In that case, savers can be incentivized not to deposit their money out of fear of not being able to get it back in the case of an emergency.

Because of that, banks are required to keep a portion of their deposits on hand, a system called “fractional reserve banking”.

The proportion of reserves that a bank must keep on hand is called the reserve requirement, and it is derived from the Federal Reserve (or the country’s local central banking system if outside of the U.S.) as a result of its monetary policy decisions.

Reserve Requirements Formula

The formula for calculating the reserve requirement consists of multiplying the reserve requirement ratio (%) by the total amount of deposits at the bank.

For example, if a bank has received $100,000 in deposits and the reserve requirement ratio is set at 5.0%, the bank must maintain a minimum cash balance of $5,000 on hand.

Bank Borrowings and Reserve Requirements

Banks can borrow money to meet their reserve requirements at the end of each day.

If a bank’s reserves do not meet the requirement, it can borrow funds from two sources:

1. Federal Reserve System (“Discount Window”)
2. Other Banks / Financial Institutions

The Fed is the most convenient place from which a bank can borrow money, as a central bank loan does not require the same time-consuming process that borrowing from another bank requires.

Additionally, loans from the Fed are as close to guaranteed as they can be.

Although the process of borrowing from the discount window is simpler, the interest paid on these loans is determined by the discount rate, which is usually higher than the rate at which loans between banks are charged, which is known as the federal funds rate.

Despite the discount window being the most common destination for overnight loans, the federal funds rate is usually lower than the discount rate, which offers some appeal to borrowing from other banks.

When banks borrow from one another, they are doing so from their excess reserves.

For example, if Bank A ends the day below its reserve requirement and Bank B ends the day with excess reserves, Bank A can fulfill its requirement by borrowing from the excess reserves of Bank B in exchange for an interest payment as determined by the federal funds rate.

Reserve Requirements and Interest Rates

The Federal Open Market Committee (FOMC) determines the federal funds rate at each of its eight yearly meetings.

Like reserve requirements, influencing the federal funds rate is one of the ways in which the Fed has control over monetary policy in the U.S.

Banks must keep at least a portion of their deposits in reserve, but that does not mean they cannot keep more than what is required on hand.

In that sense, influencing the federal funds rate can also influence reserves without actually changing the reserve requirements.

If the federal funds rate rises, banks will likely borrow less money and keep more in reserve, which has a similar effect as raising reserve requirements.

Additionally, if the Fed raises the reserve requirement, banks must keep more cash on hand, which will spur demand for borrowing due to stricter requirements, resulting in an increase in the federal funds rate based on the principles of supply and demand.

Reserve Requirements Real-Life Example: Fed and COVID-19

The reserve requirement the Fed sets can have the same rippling effects throughout the economy as the federal funds rate can.

In addition to its influence over the federal funds rate, the reserve requirement determines how much money is available for depository institutions to lend to borrowers.

If the Fed is pursuing an expansionary monetary policy, it may lower the reserve requirement so that these institutions can keep less cash on hand, which in turn, will prompt them to lend more money out.

Since the federal funds rate will likely decrease in this situation, the banks will charge a lower interest rate on loans, which prompts borrowers to borrow more money that will eventually be spent, thus expanding the economy.

A prime example of the reserve requirement being used to help stimulate the economy was seen following the economic contraction caused by the COVID-19 pandemic.

In March 2020, the Fed slashed the reserve requirement to zero, meaning banks were not required to keep any cash on hand in reserve, so banks were prompted to increase loan activity.

Once the federal funds rate was cut to near zero, widespread lending activity soon ensued in the favorable borrowing environment.