Definition: The Federal reserve requirement refers to the amount of funds that a bank must have on hand each night. 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 or 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 market.
The reserve requirement is the most important tool the Fed uses to control liquidity in the market. A low reserve requirement is expansionary monetary policy, since it allows more money in the banking system. A high reserve requirement is contractionary, since it allows less liquidity, and slows down economic activity.
The higher the reserve requirement is, the less profit a bank makes on 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 (less than less than $12.4 million in deposits) are exempted from the requirement.
Every time the Fed changes the requirement, banks have to make changes to their policies, which incurs a cost. For these reasons, the Fed rarely changes the overall reserve requirement. On the other hand, the amount of deposits subject to different reserve requirement ratios does change each year. The reserve requirement applies to commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations. (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 of 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. This gives banks an incentive to grow. The low reserve tranche and the exemption amount can be raised 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. The net amount is used, so amounts due from other banks and cash still being collected is subtracted from the total. 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
Since it's a hassle for banks, the Fed doesn't want to adjust the requirement every time it switches monetary policy. Therefore, it has many other tools that have the same effect as changing the reserve requirement. 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. This 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. This makes lending Fed funds cheaper, which has the same effect as lowering the reserve requirement.
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 wants to put this extra reserve to work, it will try to lend it to other banks, lowering the Fed funds rate to do so.
The Fed will sell securities to banks when it wants the rate to rise. Banks with fewer Fed funds to lend are able to raise the Fed funds rate. This is known as open market operations.
As the Fed funds rate rises, so too do many other rates including:
- LIBOR - the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. Rates for credit cards and adjustable-rate mortgages are usually tied to LIBOR.
- The Prime Rate - the rate banks charge their best customers. Other bank loan rates are a little higher for other customers.
- Interest Rates paid on savings accounts and money market deposits.
- Fixed Rate Mortgages and Loans - These are indirectly influenced because investors compare these loans to the yields on longer-term Treasury notes. However, higher Fed funds rates 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 to each other, or anyone else, that the Fed had to greatly expand 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. Article updated August 9, 2013