The two bank assets that can be use to satisfy reserve requirements are vault cash and Federal Reserve deposits. Reserve requirements were originally imposed on commercial banks to help avoid bank failures and related problems when did not keep enough reserves to undertake daily banking activity, including meeting cash withdrawals and processing checks.

In principle, reserve requirements also can be used as a means of a controlling the money supply. An increase in the money supply can be achieved when the Fed lowers reserve requirements. A decrease in the money supply can be achieved when the Fed raises reserve requirements. However, in practice, reserve requirements are not very flexible used only in extreme circumstances as a tool of monetary policy. Their most important role is to provide structure and stability to the banking system.

Basic Process

• First, after evaluating the state of the economy, the Fed determines whether the money supply needs to increase or decrease and by how much.


• Second, if the Fed wants to increase the money supply it lowers reserve requirements and if it wants to decrease the money supply it raises reserve requirements. The reserve requirements are set by the Board of Governors.


• Third, the higher or lower requirements mean commercial banks have to keep fewer or more reserves to back up deposits. If reserve requirements are higher, then banks have to keep more reserves. If reserve requirements are lower, then banks can keep fewer reserves.


• Fourth, the change in reserves that banks have to keep induces a change lending activity. If reserve requirements are higher, then banks have fewer reserves available for lending. If reserve requirements are lower, then banks have more reserves available for lending.


• Fifth, the change in bank lending affects the creation of checkable deposits, which are an important component of the money supply. More loans mean more deposits and an increase in the money supply. Fewer loans mean fewer deposits and a decrease in the money supply.


• Sixth, the change in bank lending also affects interest rates. If banks are willing to lend more, then interest rates fall. If banks are willing to lend less, then interest rates rise.

Lower or Higher, More or Less

• Expansionary Monetary Policy: An increase the money supply and a reduction in interest rates results when the Fed lowers reserve requirements. This is the recommended monetary policy to counter a recession, to stimulate the economy, and to reduce the unemployment rate.


• Contractionary Monetary Policy: A decrease the money supply and a boost in interest rates results when the Fed raises reserve requirements. This is the recommended monetary policy to counter an overheated expansion, to put the brakes no the economy, and to reduce the inflation rate.

Regulating Fractional Reserves

Fractional-reserve banking means that banks keep only fraction of deposits in reserve. That is, banks divide assets between non-interest-paying reserves and interest-paying loans (and other investments). This further means that banks have enough reserves available to cover only a fraction of deposits. Should too many customers seek to withdraw deposits, a bank can quickly deplete available reserves and be forced to close its doors.

Unfortunately if banks make any errors under fractional-reserve banking they are likely to keep too few reserves and make too many interest-paying loans. Before the creation of the Federal Reserve System banks frequently ran short of reserves, forcing temporary or even permanent closure, and on more than a few occasions, this triggered economy-wide bank panics and financial crises. The Fed was the established to address this problem, which it did in part through reserve requirements.

Regulation D

Under Regulation D, the Board of Governors of the Federal Reserve has the authority to impose reserve regulations on all depository institutions operating in the country, including traditional banks (national and state), savings and loan associations, credit unions, mutual savings banks, and even branches of foreign banks.

In the early years of the Fed, reserve requirements were imposed only on member banks--national banks and state banks that chose to join the Federal Reserve System. However, the Monetary Control Act of 1980 extended authority to all depository institutions, most notably savings and loan associations, credit unions, and mutual savings banks. This was done in large part to ensure uniformity among all depository institutions that issued checkable deposits and thus create a banking system and money supply that were more effectively controlled through open market operations.

Modern Requirements

Time deposits and Eurocurrency are subject to a 0 percent reserve requirement (that is, no reserves are required to back up these deposits). This has not always been the case and can change if the Fed so decides.

Net transactions deposits are subject to a three-tiered set of requirements. While the actual tiers change based on inflation, the first $7 million (or so) of deposits have a 0 percent reserve requirement, the next $40 million (or so) of deposits (termed the low reserve tranche) is subject to a 3 percent reserve requirement, and any deposits over $46 million (or so) of deposits is subject to a 10 percent reserve requirement.

The lowest tier means that banks are given a "free pass" on reserve requirements for the first $7 million (or so) of deposits, essentially excluding the very smallest depository institutions from the need to keep reserves. Slightly larger banks are then subject to modest 3 percent reserve requirements for deposits exceeding $7 million. The largest banks enter into the highest tier with reserve requirements of 10 percent.

Banks have some degree of flexibility in meeting reserve requirements. First, banks only need to satisfy requirements over a 2-week reporting period rather than each day. Second, banks have a 4 percent carry over margin (plus or minus) from one reporting period to the next.

The Board of Governors, after consulting with Congress, can also set reserve requirements outside the boundaries set by the Monetary Control Act. These emergence requirements can be in place for up to 180 days.

Making It Work For Monetary Policy

• One, reserve requirements create a stable banking structure that helps the Fed control the money supply more effectively. Reserve requirements determine the magnitude of the deposit expansion multiplier and how much the Fed needs to change reserves to achieve a given change in the money supply.


• Two, the Board of Governors does have the discretion to impose supplemental reserve requirements of 4 percentage points on depository institutions if intended for monetary policy, just the thing that might be needed to fight inflation. The Fed pays interest on these supplemental reserves and must review the decision after one year to see if it is still needed.


• Three, because reserve requirements are more important to the structure of the banking system than to the conduct of monetary policy, when they are changed, the Fed generally offsets any disruptions with open market operations or the changes are timed to reinforce a major redirection of monetary policy.

Two Other Tools

• Open Market Operations: The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.


• Discount Rate: The Fed can adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.