Reserve Requirement and How It Affects Interest Rates

How Banks Lend $9 Out of Every $10 You Deposit

reserve requirement
A low reserve requirement allows a bank to lend more to new businesses. Photo: vgajic/Getty Images

Definition: The reserve requirement is the amount of funds that a bank must have on hand each night. It is a percent of the bank's deposits. The nations' central bank sets the percentage rate.

In the United States, the Federal Reserve Board of Governors controls the reserve requirement for member banks. The reserve requirement applies to commercial banks, savings banks, savings and loan associationscredit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations.

 The bank can hold it either as cash in its vault or as a deposit at its local Federal Reserve bank. 

If the bank doesn't have enough on hand to meet its reserve, it borrows from other banks. It can also borrow from the Federal Reserve discount window. The money banks borrow or lend from each other to fulfill the reserve requirement is known as the Federal funds.

The reserve requirement is the basis of all the Fed's many tools. The Fed uses them to control liquidity in the market. A small reserve requirement is expansionary monetary policy since it allows more money in the banking system. A high reserve requirement is contractionary. It allows less liquidity and slows down economic activity.

The higher the reserve requirement, the less profit a bank makes with its money. A high requirement is especially hard on small banks since they do not have as much to lend out in the first place. That's why small banks are exempt from the requirement.

A small bank is one with  less than $12.4 million in deposits

Changing the reserve requirement is expensive. That's because banks have to modify their policies. For these reasons, the Board rarely changes the reserve requirement. Instead, it's much easier to adjust the amount of deposits subject to different reserve requirement ratios each year.

(Source: Federal Reserve Bank of New York, Reserve Requirement)

Reserve Requirement Ratio

As of October 12, 2012, the Fed required that all banks with more than $79.5 million on deposit maintain a reserve of 10% of deposits. Banks with less than $79.5 million, but more than $12.4 million (the low reserve tranche), must reserve 3% of all deposits. Banks with less than $12.4 million (the exemption amount) in deposits have a zero percent reserve requirement.

The deposit level that is subject to the different ratios rises each year. That gives banks an incentive to grow. The Fed can raise the low reserve tranche and the exemption amount can by 80% of the increase in deposit in the prior year (June 30-June 30). 

Deposits include demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturing in seven days or less. Banks use the net amount. That means they don't count the amounts due from other banks and any cash that's are still outstanding. Deposits don't include nonpersonal time deposits, and Eurocurrency liabilities as of December 27, 1990.

(Source: Federal Reserve, Reserve Requirement Table)

How the Reserve Requirement Affects Mortgage Rates

Central banks don't adjust the requirement every time they switch monetary policy. They have many other tools that have the same effect as changing the reserve requirement.

For example, the FOMC sets a target for the Fed funds rate at its regular meetings. If the Fed funds rate is high, it costs more for banks to lend to each other overnight. That has the same effect as raising the reserve requirement.

Conversely, when the Fed wants to loosen monetary policy and increase liquidity, it lowers the Fed funds rate target. That makes lending Fed funds cheaper. It has the same effect as lowering the reserve requirement. Here's the current Fed funds rate.

The Fed funds rate is the interest banks charge each other for lending Fed funds.

The Federal Bank can't mandate that banks follow its targeted rate, but it can influence the rate through its open market operations. The Fed buys securities, usually Treasury notes, from member banks when it wants the Fed funds rate to fall. The Fed adds credit to the bank's reserve in exchange for the security. Since the bank wishes to put this extra reserve to work, it will try to lend it to other banks, cutting the Fed funds rate to do so.

The Fed will sell securities to banks when it wants to increase the Fed funds rate. Banks with less Fed funds to lend can raise the Fed funds rate. That how open market operations works.

If a bank can't borrow from other banks, it can borrow from the Fed itself. Most banks try to avoid this. That's because the Fed charges a discount rate that's slightly higher than the Fed funds rate.

As the Fed funds rate rises, so too do many other interest rates including:

During the financial crisis, the Fed lowered the Fed funds rate to zero. Banks were so reluctant to lend that the Fed massively expanded its open market operations. It also needed to remove unprofitable mortgage-backed securities from banks to help them become healthy again. For more about this program, see Quantitative Easing