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 minimum funds that a bank must have on hand each night. It is a percent of the bank's deposits. The nation's 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 associations and credit unions.

It also pertains to U.S. branches and agencies of foreign banks, Edge Act corporations and agreement corporations. The bank can hold the reserve 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 may also borrow from the Federal Reserve discount window. The money banks borrow or lend to each other to fulfill the reserve requirement is known as federal funds.

The reserve requirement is the basis of all the Fed's many tools. The Fed uses these tools to control liquidity in the financial system. When the Fed reduces the reserve requirement, it's exercising expansionary monetary policy. That creates more money in the banking system. When the Fed raises the reserve requirement, it's executing contractionary policy. That reduces liquidity and slows 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. They don't have much to lend out in the first place. The Fed has exempted small banks from the requirement. A small bank is one with less than $15.5 million in deposits.

Changing the reserve requirement is expensive for banks. It forces them to modify their procedures.

As a result, the Fed Board rarely changes the reserve requirement. Instead, it adjusts the amount of deposits subject to different reserve requirement ratios. (Source: "Reserve Requirement," Federal Reserve Bank of New York.)

Reserve Requirement Ratio

As of January 19, 2017, the Fed required that all banks with more than $115.1 million on deposit to maintain a reserve of 10 percent of deposits. Banks with $115.1 million or less, but more than $15.5 million (the low reserve tranche), must reserve 3 percent of all deposits. Banks with deposits of $15.5 million or less don’t have a 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 by 80 percent of the increase in deposit in the prior year (June 30-June 30). 

Deposits include demand deposits, automatic transfer service accounts and NOW accounts. Deposits also include share draft accounts, telephone or preauthorized transfer accounts, ineligible banker’s 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 still outstanding.

Since December 27, 1990, non-personal time deposits and Eurocurrency liabilities do not require a reserve. (Source: "Reserve Requirement Table," Federal Reserve.)

How the Reserve Requirement Affects Mortgage Rates

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

For example, the Federal Open Market Committee 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 Reserve can't mandate that banks follow its targeted rate. Instead, it influences the banks’ rates 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. Banks cut their interest rates 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 work.

If a bank can't borrow from other banks, it can borrow from the Fed itself. That’s called borrowing from the discount window. Most banks try to avoid this. That's because the Fed charges a discount rate that's slightly higher than the fed funds rate. It also stigmatizes the bank. Other banks assume no other bank is willing to lend to it. They assume the bank has bad loans on its books or some other risk.

As the fed funds rate rises, these four interest rates also rise:

  1. LIBOR is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. Banks base their rates for credit cards and adjustable-rate mortgages on LIBOR.
  2. The prime rate is the rate banks charge their best customers. Other bank loan rates are a little higher for other customers.
  3. Interest rates paid on savings accounts and money market deposits also increase.
  4. Fixed rate mortgages and loans are indirectly influenced. Investors compare these loans to the yields on longer-term Treasury notes. A higher fed funds rate can drive Treasury yields a bit higher.

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