Some advertisements and offers on this page are from advertisers who pay us. That may influence which products we write about, but it does not affect what we write about them. Here's an explanation of how we make money and our Advertiser Disclosure.
The Federal Reserve, the central bank of the U.S., imposes bank reserve requirements to regulate the economy and reduce the risk of bank runs. These reserve requirements can change with current economic conditions.
Read on to learn more about how reserve requirements work and why they’re so important.
Read more: What is the Federal Reserve?
What are bank reserve requirements?
Bank reserve requirements — the amount of cash a financial institution must hold in its own vaults or with a central bank — exist to ensure that banks have enough cash to handle their obligations and customer account withdrawals. Also known as fractional reserve banking, these requirements play a critical role in the economy:
-
Economic stability: By controlling how much money a bank can lend out, central banks can use the reserve requirement as a tool to manage loans and curb inflation.
-
Consumer protection and confidence: Instituting bank reserve requirements ensures that financial institutions can meet customer demands, and customers have greater peace of mind that their money is safe and accessible.
-
Crisis prevention: The reserves also provide banks with a financial safety net, helping banks stay in operation during economic downturns.
Most countries have bank reserve requirements, but the exact requirement varies by country. It’s usually defined as a percentage of a bank's deposits. For example, if the reserve requirement is 5% and a bank has $1 million in deposits, it would need to keep at least $50,000 in cash at all times.
Banks are allowed to use their remaining deposits to make loans, invest, and perform other revenue-generating activities.
Reserve requirements and excess reserves
Bank reserves are classified as either required reserves or excess reserves.
-
Required reserves: As the name implies, required reserves are how much banks are required to keep on hand by government and regulatory authorities.
-
Excess reserves: This refers to the amount of cash a bank holds in reserve above the required amount set by government and regulatory agencies. Some banks opt to keep larger reserves as protection against market conditions, while others keep minimal reserves to maximize their ability to issue loans.
Read more: What is fractional reserve banking?
Bank reserve requirements in the U.S.
In the United States, reserve requirements apply to both banks and credit unions, though the requirement can vary by bank size.
The government instituted bank reserve requirements in 1863 as part of the National Bank Act. At that time, banks needed to maintain 25% in reserves. However, reserve requirements have evolved over time. In 2020, the Board of Governors of the Federal Reserve announced that it reduced the reserve requirement to 0%. The goal of this change was to provide banks with more cash to issue loans and jumpstart the economy.
Even so, that doesn’t mean banks are currently operating with zero cash on hand. Financial institutions typically maintain reserves to manage operational needs and regulatory compliance with other frameworks like liquidity coverage ratios.
If a bank doesn't have enough cash in its reserves, it borrows from other banks or from the Fed. The interest rate that banks charge each other for these short-term loans is called the federal funds rate, which serves as the foundation for many other interest rates in the economy.
Read more: Federal funds rate: What it is and how it affects you
How the bank reserve requirement can affect you
Thanks to the reserve requirement, you can withdraw money with confidence. For instance, if you need to withdraw a relatively large sum, you can visit a local branch, complete the withdrawal, and receive the cash immediately; you don't have to worry about the bank manager informing you that it has inadequate funds.
Bank reserve requirements, in combination with FDIC insurance, protect you from bank failures. Bank reserves make it less likely a bank will become insolvent, and the FDIC protects your deposits up to $250,000 (per depositor, per institution, per ownership category) in case the financial institution fails.
However, bank reserve requirements can affect you in other ways, including the rates you pay on auto, personal, or home loans. With a lower bank reserve, banks have a greater capacity to issue loans, so they can lower rates. When the bank reserve requirement increases, banks have less available funds, so they tighten lending requirements and raise interest rates.
Read more: Can credit unions fail?
The bottom line
Bank reserve requirements are a cornerstone of strong financial systems, and they play a major role in the U.S. economy. These requirements ensure you have ready access to your money when you need it, and it prevents bank runs and failures.
Choosing a bank that is backed by the FDIC and governed by federal regulatory agencies provides a greater level of stability so you can manage your money with confidence.
