A reserve requirement is a rule set by a central bank that obliges commercial banks to hold a minimum proportion of certain liabilities, usually customer deposits, as reserves: cash in their vaults or balances in their accounts at the central bank. The proportion is called the reserve ratio. Funds held to meet the requirement cannot be lent out or invested elsewhere.
Reserve requirements were once regarded as a central lever of monetary policy and a safeguard of bank liquidity. Their role has changed. In the United States, the Federal Reserve reduced all reserve requirement ratios to zero effective 26 March 2020, and many other central banks rely mainly on interest rates and their own operations rather than reserve ratios. Some, including the People's Bank of China and several emerging-market central banks, still use them actively.
How a reserve requirement works
A central bank defines which liabilities are reservable, for example demand deposits and short-term deposits, sets the ratio, and specifies how compliance is measured, usually as an average over a maintenance period. A bank with reservable deposits of 1 billion and a 10% requirement must hold average reserves of 100 million. If it falls short, it must borrow reserves from other banks in the interbank market, for instance in the US federal funds market at the federal funds rate, or from the central bank, or pay a penalty.
History of the reserve requirement
Early reserve rules were intended to keep banks liquid enough to meet withdrawals and avoid a bank run. In the United States, the National Bank Act of 1863 required national banks to hold reserves, and the Federal Reserve Act of 1913 made reserves at the new Federal Reserve System part of the framework. The Federal Reserve's rules are set out in Regulation D. Over time, deposit insurance, lender-of-last-resort facilities and liquidity regulation took over the job of protecting depositors, and reserve requirements came to be viewed chiefly as a monetary policy tool.
The money multiplier and its limits
Textbooks often describe reserve requirements through the money multiplier. If banks must hold 10% of deposits as reserves, an injection of 100 in reserves can support up to 1,000 in deposits, as each loan creates a deposit that is partly re-lent. On this view the central bank controls the money supply by controlling reserves and the ratio.
In practice, modern central banks target interest rates and supply whatever reserves the system needs at that rate. After the 2008 financial crisis, quantitative easing left US banks with reserves far above the required level, so the requirement no longer constrained lending. Bank lending in the US is limited instead by capital rules, liquidity rules, demand for loans and banks' own risk appetite. This is why the zero requirement adopted in 2020 did not lead to unlimited lending.
The US move to zero
In January 2019 the Federal Reserve confirmed that it would continue operating with ample reserves, controlling short-term rates mainly through the interest rate it pays on reserve balances. Congress had authorized the Fed to pay interest on reserves from October 2008. With reserves ample and interest on reserves as the main tool, the requirement served little purpose, and on 15 March 2020, at the start of the COVID-19 crisis, the Fed announced it would reduce reserve requirement ratios to zero from 26 March 2020. US banks still hold large reserve balances, but they do so for liquidity, payment settlement through systems such as Fedwire, and regulatory liquidity ratios rather than to meet a requirement.
Reserve requirements in other countries
- Euro area: the European Central Bank sets a minimum reserve ratio of 1% on certain short-term liabilities, reduced from 2% in 2012. Since 2023 those minimum reserves have been remunerated at 0%.
- China: the People's Bank of China adjusts its reserve requirement ratio frequently as an active policy tool to release or absorb liquidity.
- Emerging markets: several central banks use reserve requirements, sometimes different for local- and foreign-currency deposits, to manage credit growth and capital flows.
- Countries with none: the UK, Canada, Australia and others have no binding reserve requirement and rely on other tools.
Reserve requirement versus other buffers
A reserve requirement should not be confused with regulatory capital, which absorbs losses, or with liquidity ratios under Basel III, which require banks to hold high-quality liquid assets against expected outflows. Nor is it the same as a merchant reserve account or a country's foreign exchange reserves. In economics, reserves held at the central bank are a form of central bank money, while customer deposits are commercial bank money; the reserve requirement links the two.