Banks are required by law to keep a minimum amount of cash on hand at all times—either in an on-site vault or at a central bank. This minimum amount of cash is known as a bank reserve, and it’s set by the central bank in each country.
The Federal Reserve, which is the central bank of the U.S., sets bank reserve requirements and ensures all institutions comply with these regulations. Here’s a look at how bank reserves work and why they exist.
Definition and Examples of Bank Reserves
Bank reserves refer to the minimum amount of cash a financial institution must keep on hand to fulfill unexpected withdrawal requests from customers. The reserves exist to limit any panic that would ensue if a bank ever didn’t have enough cash on hand to meet withdrawal demands.
All depository institutions must comply with bank reserve requirements. This includes commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations.
Regulation D requires institutions to either hold their reserves in cash in an on-site vault or as a deposit at a nearby Federal Reserve bank.
There are 12 Federal Reserve facilities in the U.S., located in Atlanta; Boston; Chicago; Cleveland; Dallas; Kansas City, Missouri; Minneapolis; New York; Philadelphia; Richmond, Virginia; St. Louis; and San Francisco.
How Bank Reserves Work
Imagine this: You go to the bank to withdraw cash and the bank teller informs you they don’t have enough money on hand to fulfill your request. They decline your withdrawal, and you walk away empty-handed. Sounds frightening, right?
Bank reserves exist to make sure situations like this never happen. They can also be used as a tool to help stimulate the economy.
For example, suppose an institution has $20 million in deposits. If the Federal Reserve only requires that institution to keep 3% (i.e., $600,000) of its money in its bank reserves, then it can lend the other $19.4 million out in the form of mortgages and loans. This means more families can buy homes; more kids can go to college; and more people can buy cars, boats, and other luxury goods.
Banks earn more in interest by lending their money to the public versus keeping it at a Federal Reserve bank, which is precisely why bank reserves are so important. Without them, banks may be tempted to lend out more money than they should.
A bank’s reserves are considered an asset on its annual report. If a bank ever can’t meet the reserve requirement, it can borrow money from another bank or the Federal Reserve at the bank rate.
What Is the Bank Reserve Requirement?
The Federal Reserve Board of Governors sets the reserve requirement, also known as the bank reserve ratio, for all depository institutions in the U.S. This requirement is calculated as a percentage of the bank’s deposits.
On March 26, 2020, the Federal Reserve slashed the reserve requirement to 0% to encourage banks to lend more money to families impacted by the pandemic. It’s still in effect as of October 2021.
Prior to this change, bank reserve requirements ranged from 3% to 10% depending on the bank’s net transaction account balance. If a bank’s net transactions were more than $16.9 million up to $127.5 million, at least 3% of its balance needed to be on hand. If a bank had more than $127.5 million, it was required to keep 10%.
The thought of not being able to withdraw your cash whenever you’d like is something you may have never considered. You expect your bank to always have cash when you need it.
But prior to bank reserves, this wasn’t always the case. Banks were notorious for not keeping enough cash on hand. As soon as one bank shut down, customers at other banks would start to panic and withdraw their cash, too. This created a series of bank runs, which triggered a massive number of bank failures around the country.
The Federal Reserve System was established by Congress in December 1913 to build a more stable and secure financial system. The Federal Reserve has continued to grow since then.
After the Great Depression, the Banking Act of 1933 was passed, which established the Federal Deposit Insurance Corporation (FDIC). The Banking Act of 1935 created the Federal Open Market Committee (FOMC)—the Federal Reserve’s monetary policy-making body.
Before the 2008 financial crisis, institutions didn’t earn any interest on deposits held at their local Federal Reserve bank. This money essentially sat there, losing purchasing power to inflation—and gave banks little incentive to keep their excess cash in a reserve account instead of an on-site vault.
This changed on Oct. 1, 2008, when the Emergency Economic Stabilization Act was passed, allowing the Federal Reserve to pay interest on cash held by eligible institutions.
The interest on reserve balances (IORB) rate is set by the Board of Governors and is one of four monetary policy tools. The IORB rate has been 0.15% since July 29, 2021. This means a bank earns $1,500 in interest for every $1 million it deposits in a reserve account.
- Bank reserves refer to the minimum amount of cash banks must keep on hand for liquidity purposes. They can’t loan this money out under any circumstances.
- These reserves exist to prevent bank runs, which occur when a large number of customers withdraw their money at the same time because they believe the bank will fail.
- Banks keep their reserves in an on-site vault or at their local Federal Reserve bank. They earn a modest interest rate on reserve-held funds.
- The Federal Reserve’s Board of Governors sets the bank reserve requirement, which once ranged from 3% to 10%. As of October 2021, the bank reserve requirement is 0%.