The short version
- Banking reserves is the amount of cash a bank is required to keep on hand in the event of a large withdrawal.
- The reserve amount is set by the Federal Reserve.
- Reserves are in place to prevent a run on the bank and make sure the banking system and economy remain stable.
What are bank reserves?
When you deposit money into a bank, that money is lent out by the bank. Banks make money by charging interest on loans, which is classified as an asset on their balance sheets.
A return on assets (ROA) is one method used to measure a bank's health. However, there is a risk that if a lot of depositors ask for their money back at the same time, the bank might not have it because it's been loaned out.
That's where bank reserves come in.
Banks are required by the Federal Reserve to keep a fraction of their deposits on hand, in cash, in case of any unexpected large withdrawals.
How bank reserves work
A bank has two great fears.
- Depositors ask for their deposit back unexpectedly (called a “run on the bank”).
- Borrowers don't pay back money that was borrowed (called “defaulting” everywhere except in a bank, where it is termed “nonperforming assets”).
A bank's answer to both problems is the reserve. The bank keeps this money on hand in case problems arise. Reserves may not be spent or lent to customers. U.S. banks are required by law to keep a certain percentage of their deposits in cash. They keep this money either in the bank's vault or at a Federal Reserve Bank. The required amount is called the reserve requirement.
Keeping more cash than is required, which is the situation now at most U.S. banks, is referred to as excess reserves. A bank's reserve requirement varies by the type of deposit account (checking, certificate of deposit (CD), savings, etc.).
Reserve requirements are important because higher requirements reduce the amount of money that banks have available to lend. And since the supply of money is lower, banks charge more to lend it. That raises interest rates. So, reserve requirements indirectly influence the economy by raising and lowering interest rates.
How to calculate the reserve ratio
Imagine that for every dollar a bank has on deposit, the bank is permitted to lend ten. (In fact, banks are actually permitted to make the loans first and attract the deposits later.)
Political economist Joseph Schumpeter famously wrote:
“It is much more realistic to say that the banks “create credit,” that is, that they create deposits in their act of lending than to say that they lend the deposits that have been entrusted to them.”
In the example above, the dollar the bank has on deposit is the reserve. And the ratio of dollars that can be lent out for each dollar in reserve is called the reserve ratio. (In this example the ratio is 10%.)
The Fed sets the reserve ratio requirement for each bank based on a formula that considers the bank's net transactions and other factors. In the past U.S. bank reserve requirements have ranged from zero to around 20%.
Note that a bank reserve requirement is not the same thing as a capital requirement. Capital requirements also obligate banks to keep money in reserve. But this figure focuses on the perceived risk of their assets.
A quick history of US bank Reserves
The U.S. briefly had a national banking system under Alexander Hamilton, the first secretary of the Treasury. In 1791 Hamilton chartered The First Bank of the United States. He used it to buy up the debt that the individual states had incurred fighting the Revolutionary War. And he paid back the debt within three years. But despite this success the U.S. abandoned the central bank system 20 years later. The conflict between federal and state authorities and the loss of Hamilton's visionary leadership forced the closure.
As the industrial economy expanded following the Civil War, the weaknesses of the nation's decentralized banking system became disruptive to the economy as a whole. Bank panics or “runs” occurred regularly. Many banks held insufficient cash to meet customer withdrawals during periods of heavy demand and were forced to shut down. News of one bank running out of cash often caused panic at other banks, as worried customers rushed to withdraw money before their bank failed.
The Panic of 1907 led banker J.P. Morgan to bail out the U.S. Treasury. So Congress created the Federal Reserve System in 1913 to oversee the money supply.
During the hyperinflation of the late 1970s, Congress defined price stability as a national policy goal. It then established the Federal Open Market Committee (FOMC) within the Fed to carry out this policy. It is the FOMC that determines, among other things, reserve requirements.
More: What is the Federal Reserve?
The impact of the 2008–2009 banking crisis
Banks were not paid interest on their reserves held at a Federal Reserve Bank until the 2008 meltdown. In response to the crisis, the Fed began paying interest on bank reserves, but it did not change reserve requirements. At the same time, the Fed cut interest rates in an effort to stimulate economic activity.
The results defied expectations. Banks responded by increasing their money on deposit at the Federal Reserve Bank rather than making loans at higher rates of interest. In other words, banks preferred earning a small but dependable interest rate rather than face the uncertainties of lending during the crisis. Unable to force banks to lend, the Fed purchased government bonds issued by the U.S. Treasury in order to inject money into the economy, a process known as Quantitative Easing, or QE.
With the onset of the COVID-19 pandemic in March 2020, the Fed cut interest rates and reduced reserve requirements to zero. But stronger medicine was called for, since rates were already low and banks had more cash on hand than the reserve requirements mandated.
Impact of the COVID-19 pandemic on reserves in the US and abroad
In emerging markets and especially in China, reserve requirements are one of the main instruments by which the central banks exert control over the economy of their home countries. So when COVID-19 lockdowns began in earnest in China in April 2020, the Chinese central bank lowered reserve requirements in order to boost lending activity.
However, in most Western countries, especially in the U.S., central banks turned to open market operations. The Fed aimed to restore smooth market functioning so that credit could continue to flow. In March 2020 the Fed said that it would buy at least $500 billion in Treasury securities and $200 billion in government-guaranteed mortgage-backed securities over “the coming months.” A few days later it made the purchases open-ended, saying it would buy securities “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.” And then it eliminated reserve requirements at all U.S. depository institutions. Market function subsequently improved.
What do reserves mean to you as an investor?
The main purpose of a reserve from the customer's perspective is an antidote to panic. The reserves are there to pay you back so your withdrawal doesn't trigger a run on the bank. And the reserves are also one instrument through which the Fed seeks to influence the country's economy.
Think of the reserve requirements as the economic equivalent of a brake pedal that is applied when the economy is overheating and needs to slow down but is eased when the economy needs to grow faster.
International investors should keep reserve ratio changes in mind when investing in countries that employ reserve ratios as a monetary policy tool, such as in China and Brazil.
Since inflation tends to raise reserve requirements, investors can predict changes to bank reserve ratios by looking at underlying macroeconomic trends. A country with rising inflation may be at risk for an increase in reserve ratios. A country with deflation could be in for a decrease in reserve ratio requirements.
As mentioned, in March 2020 the Fed lowered the reserve requirement for all depository institutions to zero, essentially eliminating them. However, the FDIC, which insures depositors, still imposes capital requirements. This requires banks to maintain a certain ratio of capital to assets, depending on their perceived riskiness.
More: What is FDIC insurance?
The bottom line
Reserve requirements are being displaced by open market operations and direct lending from central banks. Reserve requirements may be nearing obsolescence. So investors in the financial sector should take into account the financial stability of the institutions they are investing in. In the event of trouble, there are no cushioning effects from reserve requirements.
An inflationary environment would require the Fed to increase the money supply. This diminishes the value of existing dollars proportionately. Debt levels are unprecedented worldwide; creditworthiness less so.