Reserve Requirement

Definition

The Reserve Requirement is how much of all deposits that a bank is required to keep “on hand”, meaning in its vaults, or on deposit at the Federal Reserve Bank (in the United States).

Details

Bank Vault, where reserve requirements are keptThe “Reserve Requirement” is about 10% of all money that has been deposited at a bank. Because of how money is created (click here for our article about How Money Is Created), banks will use deposits to make loans to people and businesses. The Reserve Requirement was first created to put a limit on how far banks can “multiply” each deposit.

The reserve requirement was much more important a hundred years ago. Back then, it was needed to make sure banks had enough cash for all the people who needed to withdraw money at any time.

Before the invention of the Federal Deposit Insurance Corporation (FDIC), depositing money at a bank could be very risky. Banks would use deposits to make loans, just like they do today. If too many people and businesses were unable to pay their loans back, it could mean the bank would go “bankrupt”, and your savings would be lost.

This meant that every time a financial crisis took place, panicked savers would rush to their bank to demand all their savings back before the bank ran out of cash. This is called a “run on the bank”, and often otherwise stable banks would be ruined under the weight of all depositors arriving to demand all of their cash back at the same time. The Reserve Requirement was created to help prevent this – savers knew that no matter what, a certain percentage of deposits would be stored in the bank vaults, not lended out, so there was less reason to run to the bank during economic instability.

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