What it means
Reserves are the most liquid thing a bank owns. They earn little or nothing compared with loans, so a bank holds them for safety and settlement rather than for profit.
Every payment between two banks ultimately moves reserve balances at the central bank. Two categories matter.
Required reserves are the legal minimum tied to customer deposits, and excess reserves are anything held above that, which the bank could in principle lend or invest. In practice many banks now sit on large excess balances because the central bank pays interest on them.
The traditional textbook story is that reserve requirements control lending. In that model a 10% requirement means $100 of new deposits supports $90 of new loans, which become deposits elsewhere, multiplying credit through the system.
Modern central banks mostly steer lending through interest rates and capital rules, and the United States set its reserve requirement to zero in 2020. For a business customer, reserves matter indirectly.
A bank comfortable on reserves has no liquidity reason to refuse a drawdown on your facility, while a bank scrambling for balances at a quarter end may price your deposit generously and your loan less so. Do not confuse bank reserves with the accounting reserves on a company's balance sheet.
A loan loss reserve, a retained earnings reserve or a warranty provision are all accounting estimates, not piles of cash, whereas a bank reserve is genuinely money on hand.
In practice
Real-world examples.
Example
A retail bank sees an unusually heavy day of business withdrawals in December and its central bank balance falls from $71,000,000 to $58,000,000. Because the requirement is $68,000,000, it borrows $10,000,000 overnight from another bank so that $58,000,000 + $10,000,000 = $68,000,000 and it ends the day compliant.
Example
A treasurer notices her bank quoting sharply better rates on 35-day deposits than on overnight money at the end of a quarter. Her relationship manager explains that the bank is managing reserve and liquidity ratios across the reporting date, and she locks in the higher rate on $5,000,000.
Example
A central bank cuts the reserve requirement from 10% to 8% to encourage lending. For a bank with $850,000,000 of reservable deposits, required reserves fall from $85,000,000 to $68,000,000, releasing $17,000,000 of idle cash into the loan book.
Formula
Calculation
Required reserves = reservable deposits x reserve requirement ratio
Excess reserves = actual reserves held - required reserves
Take a bank with $850,000,000 of reservable customer deposits in a jurisdiction with an 8% requirement. Required reserves are $850,000,000 x 0.08 = $68,000,000.
The bank actually holds $9,000,000 of vault cash and $71,000,000 on deposit at the central bank, so actual reserves are $9,000,000 + $71,000,000 = $80,000,000. Excess reserves are therefore $80,000,000 - $68,000,000 = $12,000,000.
If the central bank pays 4.4% on reserve balances, the bank earns $80,000,000 x 0.044 = $3,520,000 a year on the total. Lending the $12,000,000 of excess at 6.5% would instead earn $12,000,000 x 0.065 = $780,000 against the $12,000,000 x 0.044 = $528,000 it currently earns, so the comfort of that cushion costs about $252,000 a year in forgone margin.Case study
Seen in the real world.
Northlake Community Bank is an invented lender used here for illustrative purposes only. It held $80,000,000 of reserves against a $68,000,000 requirement, a cushion its board considered generous, until a single agricultural customer withdrew $22,000,000 at two days' notice to complete a land purchase.
The withdrawal took actual reserves to $58,000,000, below the $68,000,000 minimum, so Northlake borrowed $10,000,000 overnight for eleven days. Paying roughly 5.4% while earning 4.4% on its own balances, the extra interest cost was about $3,000, which nobody would call a crisis.
The board's reaction was the interesting part. It introduced a rule requiring 30 days' notice on withdrawals above $5,000,000 from the ten largest accounts, and the illustrative bank now models its reserve position against its five largest possible outflows rather than against the regulatory minimum alone.
Watch out
Common mistakes.
- Believing bank reserves are a pot of money set aside for future losses. That is a loan loss provision; a bank reserve is cash and central bank balances used for settlement.
- Assuming a zero reserve requirement means banks hold no reserves. Banks hold large balances anyway for payments, for liquidity rules and for the interest the central bank pays on them.
- Treating reserves and capital as the same cushion. Reserves are an asset on the balance sheet, capital is funding on the other side, and a bank can have plenty of one and too little of the other.
Questions
People also ask.
Where do reserves actually sit?
Partly as banknotes in the bank's vaults and cash machines, and mostly as an electronic balance in the bank's account at the central bank.
Do reserves earn interest?
In most major economies yes, the central bank pays a policy-linked rate on reserve balances, which is why excess reserves are no longer expensive to hold.
Does a higher reserve requirement always reduce lending?
It tightens conditions at the margin, but banks can raise deposits or borrow to meet it, so the effect is smaller than the simple multiplier model suggests.
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