Reserve Requirement and How It Affects Interest Rates

The reserve requirement is the total amount of funds a bank must have on hand each night. It is a percentage of the bank's deposits. A 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 bank can hold the reserve either as cash in its vault or as a deposit at its local Federal Reserve bank.

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.

How the Reserve Requirement Works

Suppose a bank has $1,000,000 in deposits. Each night, it must hold $100,000 in reserve. That allows it to lend $900,000. That increases the amount of money in the economy. The loans help businesses expand, families buy homes, and students attend school. Having $100,000 on hand makes sure it has enough to meet withdrawals. Without the reserve requirement, the bank might be tempted to lend all the money.

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 that banks borrow or lend to one another to fulfill the reserve requirement is called "federal funds." The interest they charge one another to borrow fed funds is the fed funds rate. All other interest rates are based on that rate.

The Federal Reserve (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.

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. 

Reserve Requirement Ratio

On March 15, 2020, the Fed announced it had reduced the reserve requirement ratio to zero effective March 26, 2020. It did so to encourage banks to lend all of their funds during the COVID-19 coronavirus pandemic. As of January 2022, this reserve requirement was still in effect.

Prior to the March 15 announcement, the Fed had just updated its reserve requirement table on Jan. 16, 2020. It required that all banks with more than $127.5 million on deposit maintain a reserve of 10% of deposits.

Banks with more than $16.9 million up to $127.5 million had to reserve 3% of all deposits. Banks with deposits of $16.9 million or less didn’t have a reserve requirement. A high requirement is especially hard on small banks. They don't have as much money to lend in the first place.

An Incentive to Grow

The Fed raises the deposit level that is subject to the different ratios each year. That gives banks an incentive to grow. The Fed can raise the low reserve tranche and the exemption amount by 80% depending on the increase in deposits in the prior year. The Fed's fiscal year runs from July 1 to 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 Dec. 27, 1990, nonpersonal time deposits and eurocurrency liabilities have not required a reserve.

How the Reserve Requirement Affects Interest Rates

Raising the reserve requirement reduces the amount of money that banks have available to lend. Since the supply of money is lower, banks can charge more to lend it. That sends interest rates up.

Changing the requirement is expensive for banks. For that reason, central banks don't want to adjust the requirement every time they shift monetary policy. Instead, they have many other tools that have the same effect as changing the reserve requirement.

If the fed funds rate is high, it costs more for banks to lend to one another 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.

Open Market Operations

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 fewer fed funds to lend can raise the fed funds rate. That is how open market operations work.

Borrowing from the Discount Window

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 doing that 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.

Interest Rates Rise

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

1. LIBOR is the interest rate banks charge one another 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 of 2008, the Fed lowered the fed funds rate to zero. Interest rates were as low as they could be. Still, banks were reluctant to lend. They had so many bad loans on their books that they wanted to conserve cash to write off the bad debt. They were also hesitant to take on more potentially risky debt.

This forced the Fed to massively expand its open market operations with the quantitative easing program. The Fed also removed some unprofitable mortgage-backed securities from its member banks.

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