What it means
When you deposit money, your bank does not keep all of it in a vault. It lends most of it out, which is how banks earn their living, but it must hold back a slice that stays available.
That slice, set by regulation as a percentage of certain deposits, is the required reserve. The central bank sets the reserve ratio (the percentage of deposits that must be held back) and defines which deposits count.
Banks can meet the requirement with cash in their own vaults and with balances held at the central bank. Any amount above the minimum is called excess reserves.
Required reserves matter for two reasons. They act as a safety cushion, although in a real run on a bank the cushion is far too small to meet every withdrawal.
They also limit how much a bank can lend, because every new loan creates a deposit that needs its own reserve. The textbook link is the money multiplier, which says that the maximum growth in deposits from a new reserve is 1 divided by the reserve ratio.
In practice, modern banks are constrained more by capital rules, liquidity rules and the demand for loans than by the reserve ratio alone. Practice varies between countries.
Some central banks have lowered the requirement to zero or have never used one, and instead steer the economy through interest rates and by paying interest on reserve balances. A business owner meets this topic indirectly.
When a central bank changes the ratio or the rate paid on reserves, it changes how costly it is for banks to lend, which can feed through to loan pricing and credit availability.
In practice
Real-world examples.
Example
A community bank receives a $20,000,000 deposit from a local company. With a 10% reserve ratio it must set aside $2,000,000 as required reserves and may lend out the remaining $18,000,000.
Example
A central bank wants to slow credit growth in an overheating property market. It raises the reserve ratio, so commercial banks must hold more back and have less to lend, which pushes up borrowing costs for developers.
Example
A treasury manager at a regional bank sees reserves dipping close to the minimum at month end. She borrows overnight from another bank to cover the shortfall, paying a short-term interest rate for the convenience. Because reserves are often averaged over a maintenance period, she also notes that balances can dip on some days if they are rebuilt on others.
Formula
Calculation
Required reserves = reservable deposits x reserve ratio; Excess reserves = actual reserves - required reserves.
Suppose a bank has $500,000,000 of reservable deposits and the reserve ratio is 10%. Required reserves = 500,000,000 x 0.10 = $50,000,000. If the bank actually holds $58,000,000 in cash and central bank balances, excess reserves = 58,000,000 - 50,000,000 = $8,000,000. With a 10% ratio, the textbook money multiplier is 1 / 0.10 = 10, so $8,000,000 of excess reserves could in theory support up to $80,000,000 of new deposits.Case study
Seen in the real world.
Meridian Trust is an illustrative, fictional mid-sized bank with $2,000,000,000 in reservable deposits. The central bank in its country announced that the reserve ratio would rise from 8% to 10% over three months.
The chief financial officer calculated the effect. Required reserves would rise from $160,000,000 to $200,000,000, locking up an extra $40,000,000 that would otherwise have been lent at an average rate of 6%, a loss of roughly $2,400,000 a year in interest income.
Meridian responded by trimming its lowest-return loans, raising some loan pricing and selling a portion of its bond holdings to build the reserve. The treasury team also moved its daily cash forecasting to an hourly view, so that it never drifted below the new minimum at the end of a maintenance period. The illustrative lesson is that a small change in a ratio can have a multi-million effect on earnings.
Watch out
Common mistakes.
- Thinking required reserves are a guarantee that every depositor can be repaid at once, when the reserve is only a small fraction of deposits.
- Assuming that all central banks use reserve requirements in the same way, when some have set them at zero and rely on rates instead.
- Confusing required reserves with capital, since reserves are assets held against deposit liabilities while capital is the owners' cushion against losses.
Questions
People also ask.
Who decides the required reserve ratio?
The central bank, usually within limits set by legislation, which may set different ratios for different types of deposit and for banks of different sizes.
Do banks earn interest on required reserves?
In many systems the central bank pays interest on reserve balances, which reduces the cost of holding them, though the rate and the rules vary from one country to the next and can change with policy.
What happens if a bank falls short of its requirement?
It usually faces a penalty or must borrow the shortfall, often from other banks or from the central bank at a higher rate.
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