Reserve Requirement (Cash Reserve Ratio)

Definition

The term reserve requirement refers to a commercial bank obligation to hold in reserve a percentage of their deposits. Reserve requirements are established an enforced by a country's central banking authority.

Explanation

Also referred to as the cash reserve ratio, the reserve requirement specifies how much money a commercial bank must set aside and hold on reserve. The requirement is based on the deposits and / or liabilities of the commercial bank and is established by the central banking authority. For example, if the reserve requirement was 3%, and the bank had liabilities of $100,000,000, then their reserve requirement would be $3,000,000. In the United States, the reserve requirement is established by the Federal Reserve.

Typically, a bank's reserve would include currency physically held in the vaults of the bank plus their account balance with the central bank. In 2018, banks with liabilities that totaled less than $16.0 million had no reserve requirement. Banks with liabilities that ranged from $16.0 million to $122.3 million had a reserve requirement of 3%. If a bank had liabilities of more than $122.3 million, then their reserve requirement was 10%. If a bank is not able to meet its reserve requirement using its own resources, it can borrow from a bank that has excess reserves. The interest rate charged on these overnight loans is known as the fed funds rate.

The reserve requirement is one of three tools the Federal Reserve can use to meet the objectives of their monetary policy. Increasing or decreasing the reserve requirement has a direct effect on how much lending occurs in an economy, thereby slowing down or fostering economic growth.

Related Terms

open market operations, monetary policy, contractionary monetary policy, expansionary monetary policy, Federal Funds rate, fiscal policy