what are reserve requirements 
reserve requirements are the amount of cash that financial institutions must have in their vaults or at the closest federal reserve bank in line with deposits made by their customers set by the fed s board of governors reserve requirements are one of the three main tools of monetary policy the other two tools are open market operations and the discount rate banks credit unions and savings and loan associations must meet reserve requirements so must u s branches and agencies of foreign banks edge act corporations and agreement corporations 1on march 15 2020 the federal reserve board announced that reserve requirements ratios would be set to 0 effective march 26 2020 prior to the change effective march 26 2020 the reserve requirement ratios on net transactions accounts differed based on the amount of net transactions accounts at the institution 1understanding reserve requirementsbanks loan funds to customers based on a fraction of the cash they have on hand the government makes one requirement of them in exchange for this ability keep a certain amount of deposits on hand to cover possible withdrawals this amount is called the reserve requirement and it is the percentage that banks must keep in reserve and are not allowed to lend if a bank doesn t have enough cash to meet the reserve requirement it borrows from other banks or from the fed s discount window the interest banks charge each other to borrow is called the federal funds rate and it s the basis for many other interest rates in the economy the federal reserve s board of governors sets the requirement as well as the interest rate banks get paid on excess reserves the financial services regulatory relief act of 2006 gave the federal reserve the right to pay interest on excess reserves the effective date on which banks started getting paid interest was oct 1 2011 2 this rate of interest is referred to as the interest rate on excess reserves and serves as a proxy for the federal funds rate the reserve requirement is another tool that the fed has at its disposal to control liquidity in the financial system by reducing the reserve requirement the fed is executing an expansionary monetary policy and conversely when it raises the requirement it s exercising a contractionary monetary policy this latter action cuts liquidity and causes a cool down in the economy in other words when the fed raises reserve requirements banks have less to lend out to consumers and businesses that in turn raises interest rates when the fed drops reserve requirements the opposite happens interest rates fall reserve requirements historythe practice of holding reserves started with the first commercial banks during the early 19th century each bank had its own note that was only used within its geographic area of operation exchanging it to another banknote in a different region was expensive and risky because of the lack of information about funds at the other bank to overcome this problem banks in new york and new jersey arranged for voluntary redemption at each other s branches on the condition that the issuing bank and redeeming bank both maintained an agreed upon deposit of gold or its equivalent subsequently the national bank act of 1863 imposed 25 reserve requirements for banks under its charge 3 those requirements and a tax on state banknotes in 1865 ensured that national bank notes replaced other currencies as a medium of exchange the creation of the federal reserve and its constituent banks in 1913 as a lender of last resort further eliminated risks and costs required in maintaining reserves and pared down reserve requirements from their earlier high levels 4 for example reserve requirements for three types of banks under the federal reserve were set at 13 10 and 7 in 1917 5in 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 the day president woodrow wilson signed the federal reserve act into law thus creating the federal reserve 6reserve requirements vs capital requirementssome countries don t have reserve requirements these countries include canada the united kingdom new zealand australia and sweden 7 instead some of these countries must adhere to capital requirements which is the amount of equity a bank or financial institution must hold as required by its financial regulator reserve requirements refer to the amount of liquid assets a bank must hold these funds are intended to protect the institution from runs on deposits a financial institution can hold additional funds above the required amount known as free reserves capital requirements are meant to absorb losses on loans and other investments 8example of reserve requirementsas an example assume a bank has 200 million in deposits and is required to hold 10 the bank is now allowed to lend out 180 million which drastically decreases bank credit the amount of money the loans the bank can make to customers in addition to providing a buffer against bank runs and a layer of liquidity reserve requirements are also used as a monetary tool by the federal reserve by increasing the reserve requirement the federal reserve is essentially taking money out of the money supply and increasing the cost of credit lowering the reserve requirement pumps money into the economy by giving banks excess reserves which promotes the expansion of bank credit and lowers rates who sets the reserve requirement in the united states the federal reserve board sets the reserve requirements the federal reserve board receives its authority to set reserve requirements from the federal reserve act the board establishes reserve requirements as a way to carry out a monetary policy on deposits and other liabilities of depository institutions 