What it means
Central banks that use reserve requirements do not apply them to every liability a bank has. They define a list of deposit types, called reservable deposits or reservable liabilities, and the reserve requirement is a percentage of that list.
The idea behind the definition is liquidity. Money that customers can withdraw or spend at a moment's notice is the riskiest for a bank, so these transaction accounts are usually the ones that carry the requirement.
Time deposits, such as a savings certificate locked for a year, are often outside the definition or carry a zero ratio. The bank knows when that money will leave, so it has more time to prepare.
The requirement is sometimes tiered. A small amount of deposits might be exempt, the next slice might carry a low ratio, and anything above that might carry a higher ratio, which spares small banks the heaviest burden.
Banks track the figure carefully, because reporting it wrongly can produce penalties and extra scrutiny from the regulator. The calculation is normally done on an average over a reporting period, and a bank that misclassifies a deposit may find itself holding too little or locking up too much cash.
Practice differs between countries, and some central banks have reduced their ratios to zero in recent years. The definitions and any ratios should therefore always be taken from the current regulation of the relevant central bank.
In practice
Real-world examples.
Example
A business current account holds $250,000 that its owner can use any day to pay suppliers. The bank counts the balance as a reservable deposit, because it is a transaction account and can be withdrawn without notice. If the owner moves the money into a fixed term account, the balance may stop being reservable, which changes how much the bank must hold back.
Example
A customer places $500,000 in a three-year fixed deposit. In a system where long-term time deposits carry a zero ratio, the bank does not have to hold reserves against that amount. Its treasury team can therefore plan to lend or invest more of that money, knowing it cannot be withdrawn on demand without a penalty.
Example
A small credit union with $15,000,000 of reservable deposits finds that its balance falls inside the exempt tier. It holds no required reserve, and its finance manager can lend a larger share of deposits than a larger bank could. The manager still reports the figures each period, because the exemption depends on staying within the threshold.
Formula
Calculation
Required reserve = sum of (reservable deposits in each tier x ratio for that tier).
Suppose, purely as an illustration, a central bank applies a tiered scheme to a bank with $100,000,000 of reservable deposits. The first $20,000,000 carries 0%, the next $60,000,000 carries 3%, and the remaining $20,000,000 carries 10%. Required reserve = (20,000,000 x 0) + (60,000,000 x 0.03) + (20,000,000 x 0.10) = 0 + 1,800,000 + 2,000,000 = $3,800,000.Case study
Seen in the real world.
Lantern Bank is an illustrative, fictional regional lender that marketed a new high-interest savings account. The product allowed unlimited withdrawals and transfers, and thousands of customers moved money into it.
The compliance manager asked whether the new accounts were reservable. After reading the regulator's definition she concluded that, because customers could make unlimited transfers, the accounts behaved like transaction accounts, and about $40,000,000 of balances should be reported as reservable.
At a 10% ratio that created an additional requirement of $4,000,000, which Lantern had not budgeted. The illustrative lesson is that product design can change regulatory classification, so the finance team should be consulted before a new account is launched. Lantern now includes a regulatory classification check in the approval checklist for every new deposit product, and records the reasoning so that it can be shown to the supervisor on request.
Watch out
Common mistakes.
- Assuming every deposit counts for reserve purposes, when many central banks exclude long-term time deposits or apply a lower ratio.
- Classifying a deposit by its marketing name, when regulators look at how easily the money can be moved or spent.
- Ignoring tiers and exemptions, which can make the real requirement much smaller than a flat percentage suggests and lead to overestimating the cost of holding reserves.
Questions
People also ask.
Which deposits are usually reservable?
Transaction accounts such as current accounts and other deposits that customers can withdraw or transfer on demand are the usual core of the definition.
Does a reservable deposit mean the money is locked away?
No, the customer can still use the money, but the bank has to keep part of the total in reserve against it.
Why do some central banks no longer use reserve requirements?
They have found that setting interest rates and paying interest on reserve balances controls conditions more precisely, so the ratio is set to zero or abolished.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related