Why the Fed removed the reserve requirement
Kimberly Amadeo is an expert on U.S. and world economies and investing, with over 20 years of experience in economic analysis and business strategy. She is the President of the economic website World Money Watch. As a writer for The Balance, Kimberly provides insight on the state of the present-day economy, as well as past events that have had a lasting impact.
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Updated December 31, 2021
Reviewed byErika Rasure
Erika Rasure, is the Founder of Crypto Goddess, the first learning community curated for women to learn how to invest their money—and themselves—in crypto, blockchain, and the future of finance and digital assets. She is a financial therapist and is globally-recognized as a leading personal finance and cryptocurrency subject matter expert and educator.
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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.
The reserve requirement is the basis for all the Fed's other tools.
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.
The higher the reserve requirement, the less profit a bank makes with its money.
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 shiftmonetary policy. Instead, they havemany other toolsthat have the same effect as changing the reserve requirement.
The Federal Open Market Committee sets a target for thefed funds rateat its regular meetings.
If the fed funds rate is high, it costs more for banks to lend to one another overnight. That hasthe same effect as raising the reserve requirement.
Conversely, when the Fed wants to loosenmonetary policyand 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 thecurrent fed funds rate.
Open Market Operations
TheFederal Reservecan't mandate that banks follow itstargeted rate. Instead, it influences the banks’ rates through itsopen market operations. TheFed buyssecurities, usually Treasury notes, from member banks when it wants the fed funds rate to fall. The Fed addscredit to the bank'sreserve 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. Bankscuttheir interest ratesto do so.
The Fed will sell securities to banks when it wants toincrease the fed funds rate. Bankswith fewer fed funds tolend can raise the fed funds rate.That is howopen market operationswork.
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 adiscount ratethat'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 fourinterest rates also rise:
- LIBORis the interest rate banks charge one another for one-month, three-month, six-month, and one-year loans. Banks base their rates forcreditcardsandadjustable-rate mortgageson LIBOR.
- Theprime rateisthe rate bankscharge their best customers.Other bank loan ratesare a little higher for other customers.
- Interest ratespaid on savings accounts andmoney market deposits also increase.
- Fixed-rate mortgages and loansare indirectly influenced. Investors compare these loans to theyieldson longer-termTreasury 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 thequantitative easingprogram. The Fedalso removed someunprofitable mortgage-backed securitiesfrom its member banks.
- The federal reserve requirement is the amount of money the Federal Reserve requires its member banks to store in its vaults overnight.
- Requiring banks to have a reserve requirement serves to protect them and their customers from a bank run.
- When the Fed adjusts the reserve requirement, it allows banks to charge lower interest rates.
- Banks often take on a financial burden when limits change, so the Fed often uses open market operations instead to influence banks.
Frequently Asked Questions (FAQs)
What does lowering the reserve requirement do?
Reducing the reserve requirement frees up more money to circulate through the economy, which creates more demand. According to Keynesian economic theory, boosting demand with these sorts of measures stimulates an economy.
What is the current reserve requirement?
The Federal Reserve has currently suspended the reserve requirement. The reserve requirement was reduced to 0% in March 2020, and it has remained there since.
In response to the COVID-19 pandemic, the Federal Reserve reduced the reserve requirement ratio to zero across all deposit tiers, effective March 26, 2020. 1 The aim of this reduction was to jump-start the economy by allowing banks to use additional liquidity to lend to individuals and businesses.Did the Fed eliminate the reserve requirement? ›
As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.Why is lowering the reserve? ›
The Federal Reserve can increase the money supply by lowering the reserve requirement. a. Lowering the reserve requirement increases excess reserves in the system, thereby increasing loan activity.Why does the Fed have reserve requirements? ›
The Federal Reserve's Reserve Requirement is essential for the stability of our economy as well as the financial security of individuals, families, businesses and financial institutions. Requiring banks to have a reserve requirement serves to protect them and their customers from a bank run.Why does the Fed rarely change the reserve requirement? ›
The higher the reserve requirement, the less profit a bank makes with its money. 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.What does changing the reserve requirement do? ›
Increasing the (reserve requirement) ratios reduces the volume of deposits that can be supported by a given level of reserves and, in the absence of other actions, reduces the money stock and raises the cost of credit.What are the disadvantages of reserves? ›
Impractical in Nature: Reserve requirements are impractical to a certain extent as even the slightest of alterations in the required cash-reserve ratio might lead to major changes in the supply of money. The outcome of this impracticality could be really expensive for banking institutions.What is the reserve requirement right now? ›
The Federal Reserve requires banks and other depository institutions to hold a minimum level of reserves against their liabilities. Currently, the marginal reserve requirement equals 10 percent of a bank's demand and checking deposits.What does changing the reserve requirement do quizlet? ›
By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.What happens when the reserve requirement is zero? ›
By setting reserve requirements to zero, the Fed will increase excess reserves, and thus the stock of liquid assets eligible to meet supervisory regulations and expectations, dollar-for-dollar.
By raising reserve requirements what happens? The Fed reduces the money-creating potential of the banking system and tends to reduce the money supply. A higher reserve requirement also lowers the deposit expansion multiplier.What is the example of reserve requirement? ›
How Do Reserve Requirements Work? For example, Bank XYZ has $400 million in deposits. The Federal Reserve's reserve requirement is 10%, which means that Bank XYZ must keep at least $40 million in an account at a Federal Reserve bank and may not use that cash for lending or any other purpose.Why does the Federal Reserve rarely change the reserve requirement multiple choice question? ›
Why does the Fed rarely change the reserve requirements? A small increase in the Required Reserve Ratio would force banks to call in significant numbers of loans. What activities creates money?Why is the effect of Federal Reserve actions on bank reserves less exact than the effect on the monetary base? ›
Because the Fed cannot control the distribution of the monetary base between reserves and currency, it has less control over reserves than the base.What is the most likely reason the Fed would raise the interest rate on required and excess reserves? ›
Increase interest rates in order to decrease the money supply. The process by which the Federal Reserve controls the supply, availability, and cost of money in order to keep the economy stable is know as which of the following? monetary policy.What will happen to the money supply if the Fed increases the reserve requirement? ›
When the Fed raises the reserve requirement on deposits, the money supply decreases. When the Fed lowers its target federal funds rate and discount rate, it signals an expanded U.S. money supply and lower overall interest rates.What does a decrease in the reserve requirement cause quizlet? ›
It will decrease the money supply. less reserves and the money supply tends to grow. more reserves and the money supply tends to grow.How reserve requirements affect money supply? ›
The Fed can influence the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.Why is reserve important? ›
Reserves help in strengthening the financial position of the business enterprise. They are not created to meet any liabilities, contingencies or commitments. It is important to mention here that the business cannot create reserves in anticipation of some losses; however, in case of loss, reserves can be utilized.How does reserve requirement control inflation? ›
Conversely, the Fed increases the reserve ratio requirement to reduce the amount of funds banks have to lend. The Fed uses this mechanism to reduce the supply of money in the economy and control inflation by slowing the economy down.
The reserve ratio is the amount of reserves—or cash deposits—that a bank must hold on to and not lend out. The greater the reserve requirement, the less money that a bank can potentially lend—but this excess cash also staves off a banking failure and shores up its balance sheet.What is the reserve requirement quizlet? ›
Required reserves def. the amount of reserves banks must hold in their vault or with the Fed that they can't lend out (as a percent of deposits) increased reserve requirement -> banks must hold more deposits as reserves, thus reducing the amount available for loans.What can the Federal Reserve do to encourage banks to lend out more of their reserves? ›
- Reducing the Discount Rate.
- If the Fed wants to encourage banks to loan out more of their money, it may reduce the discount rate, making it easier or cheaper for banks to borrow money if their reserves fall too low.
- Reducing the discount rate causes banks to lend out more money, which increases the money supply.