Key Takeaways
- Bank reserves refer to the minimum amount of cash banks must keep on hand for liquidity purposes.
- Reserves exist to prevent bank runs, which occur when a large number of customers withdraw their money at the same time.
- Banks keep their reserves in an on-site vault or at their local Federal Reserve bank and earn a modest interest rate on reserve-held funds.
- The Federal Reserve’s Board of Governors sets the bank reserve requirement.
Definition and Examples of Bank Reserves
The bank reserves exist to limit any panic that would dream if a bank ever didn’t have enough cash on hand to meet withdrawal demands. Conversely, unexpected requests are covered by short-term and overnight borrowing from the Fed.
All depository institutions must comply with bank reserve requirements. This includes commercial banks, savings banks, savings and loan associations, credit unions, US branches and agencies of foreign banks, Edge corporations, and agreement corporations.
Regulation D requires institutions to either hold their reserves in cash in an on-site vault or as a deposit at a nearby Federal Reserve bank.
How Bank Reserves Work
Imagine this: You go to the bank to withdraw cash and the bank teller informs you there is not enough money on hand to fulfill your request and your withdrawal is declined. Sounds frightening, right? Bank reserves exist to make sure situations like this never happen.
Reserves are also used as a tool to help stimulate the economy. Suppose an institution has $20 million in deposits. If the Federal Reserve only requires that institution to keep 3% (ie, $600,000) of its money in its bank reserves, then it can lend the other $19.4 million out in the form of mortgages and loans. Families can buy homes, kids can fund college, and more people can buy cars, boats, and other luxury goods.
Banks earn interest by lending their money to the public versus holding it at a Federal Reserve bank, which is precisely why bank reserves are important. Without held reserves, banks may be tempted to lend out more money than they should.
A bank’s reserves are considered an asset on its annual report. If a bank cannot meet the reserve requirement, it can borrow money from another bank or the Federal Reserve at the bank rate.
What Is the Bank Reserve Requirement?
The Federal Reserve Board of Governors sets the reserve requirement, also known as the bank reserve ratio, for all depository institutions in the US and is calculated as a percentage of the bank’s deposits.
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There are 12 Federal Reserve facilities in the US, located in Atlanta; Boston; Chicago; Cleveland; Dallas; Kansas City, Missouri; Minneapolis; New York; Philadelphia; Richmond, Virginia; St.Louis; and San Francisco.
On March 26, 2020, the Federal Reserve slashed the reserve requirement to 0% to encourage banks to lend more money to families impacted by the pandemic. It’s still in effect as of October 2021.
Before this change, bank reserve requirements ranged from 3% to 10% depending on the bank’s net transaction account balance. If a bank’s net transaction accounts were more than $16.9 million up to $127.5 million, at least 3% of its balance needed to be on hand. If a bank had more than $127.5 million, it was required to keep 10%.
The Federal Reserve System
Before the use of bank reserves, banks were notorious for not keeping enough cash on hand. If one bank closed, customers at other banks would panic and withdraw their cash, creating a series of bank runs. The Federal Reserve System was established by Congress in December 1913 to build a more stable and secure financial system.
After the Great Depression, the Banking Act of 1933 was passed, which established the Federal Deposit Insurance Corporation (FDIC). The Banking Act of 1935 created the Federal Open Market Committee (FOMC)—the Federal Reserve’s monetary policy-making body.
Before the 2008 financial crisis, institutions did not earn any interest on deposits held at their local Federal Reserve bank. This changed on Oct. 1, 2008, when the Emergency Economic Stabilization Act was passed, allowing the Federal Reserve to pay interest on excess reserves held by eligible institutions.
The interest on reserve balances (IORB) rate is set by the Board of Governors and is one of four monetary policy tools. The IORB rate has been 0.15% since July 29, 2021. This means a bank earns $1,500 in interest for every $1 million in deposits in a reserve account.