Reserve Requirement

Published Jan 7, 2023

Definition of Reserve Requirement

A reserve requirement is a regulation imposed by a central bank on commercial banks and other financial institutions. It requires them to hold a certain percentage of their deposits in the form of reserves. That means they have to keep a certain amount of all their deposits in their own vaults or on deposit with the central bank.

Example

To illustrate this, let’s look at a fictional bank called ABC Bank. ABC Bank has USD 100 million in deposits. Now, assume the central bank imposes a 10% reserve requirement on ABC Bank. That means ABC Bank has to keep 10% of its deposits, or USD 10 million, in its own vaults or on deposit with the central bank. The remaining USD 90 million can be used to make loans or investments. That way, if ABC Bank wants to increase its loan portfolio, it has to increase its deposits first. That means it has to attract more customers and convince them to deposit their money with ABC Bank.

Why Reserve Requirements Matter

Reserve requirements are an important tool for central banks to control the money supply and the credit creation process. By increasing or decreasing the reserve requirement, central banks can influence the amount of money that commercial banks can lend out. This, in turn, affects the money supply and the interest rates in the economy. Thus, reserve requirements are an important tool for central banks to keep inflation in check (along with open market operations and discount rates).