Reserve Requirement
A reserve requirement is a regulation that obliges banks to hold a minimum fraction of their deposits as reserves, either as cash or as balances at the central bank. It is one of the traditional instruments of monetary policy and of prudential regulation, though its role has diminished in many advanced economies.
Purpose and Operation
Reserve requirements serve several purposes. As a monetary instrument, they influence the money multiplier and thus the relationship between reserves and the money supply. As a prudential measure, they ensure a buffer of liquid assets. As a source of revenue, they can generate seigniorage for the central bank, since required reserves often earn no or below-market interest.
The requirement is typically specified as a ratio of eligible liabilities, with the eligible liabilities and the reserve assets defined by the central bank. In some systems the requirement is averaged over a maintenance period, smoothing the demand for reserves and reducing the volatility of short-term rates.
Monetary Policy Role
In the era of monetary targeting, reserve requirements were an important instrument, since they determined the relationship between reserve money and the broader money supply. Changes in the requirement altered the money multiplier and thus the quantity of money supported by a given quantity of reserves.
As monetary policy shifted toward interest rate targeting, the role of reserve requirements declined. With interest rate targets, the quantity of reserves is adjusted to achieve the target rate, and the requirement is less important as a monetary instrument. Its prudential role, meanwhile, has been largely superseded by liquidity regulation.
Recent Trends
Many central banks have reduced or eliminated reserve requirements, particularly where the framework operates with ample reserves and where the interest on reserves is the main tool for steering rates. Some jurisdictions have set the requirement to zero, relying on liquidity regulation and supervision to ensure adequate buffers.
Where requirements remain, they are often used for macroprudential purposes, adjusted to lean against credit cycles. Emerging market central banks, in particular, have used reserve requirements actively as a countercyclical tool, raising them during credit booms and lowering them during downturns.
Comparison with Liquidity Regulation
Modern liquidity regulation, including the liquidity coverage ratio and the net stable funding ratio, addresses liquidity risk more comprehensively than reserve requirements. These standards require banks to hold high-quality liquid assets and to maintain stable funding, targeting the resilience of the balance sheet rather than simply the level of reserves.
Reserve requirements nonetheless retain a role in some systems, particularly where liquidity regulation is less developed or where the central bank uses the requirement for monetary or macroprudential purposes. The design of the requirement, including its level and its application, reflects the objectives it is intended to serve.
Monetary Policy Implementation
In traditional monetary policy implementation, reserve requirements determined the demand for reserves and thereby the relationship between reserves and the money supply. The central bank could influence the money supply by controlling the supply of reserves, given the requirement.
In modern frameworks, the central bank typically targets an interest rate and supplies reserves as needed to achieve it. The reserve requirement matters less for the implementation of policy, though it still shapes the demand for reserves and thus the operations the central bank must conduct to achieve its target.
Reserve Requirements and Bank Behaviour
Reserve requirements affect bank behaviour beyond the mechanical relationship with the money supply. They raise the cost of deposits relative to other funding sources, since reserves earn a lower return. Banks may respond by shifting toward non-deposit funding, by raising fees, or by reducing deposit rates, with implications for the composition of bank liabilities and for the transmission of policy.
The response of banks to reserve requirements is an important consideration in the design of the instrument. Where the requirement is high, banks may seek to economise on reserves through financial innovation, undermining the effectiveness of the instrument and complicating the interpretation of monetary aggregates.
Cross-Country Variation
Reserve requirements vary widely across countries. Some central banks set them at relatively high levels, particularly in economies where they are used for macroprudential purposes or where the demand for reserves is difficult to manage by other means. Others have reduced them to low levels or eliminated them, relying on interest on reserves and liquidity regulation.
The variation reflects differences in financial structure, in the objectives of policy, and in the available instruments. The comparison of experience across countries informs the assessment of when reserve requirements are useful and how they should be designed.
Relationship to Capital Requirements
Reserve requirements and capital requirements are distinct instruments. Capital requirements address the solvency of banks, ensuring that they have sufficient equity to absorb losses. Reserve requirements address liquidity, ensuring that banks hold sufficient liquid assets to meet withdrawals.
The two instruments interact, since both affect the cost of intermediation and the behaviour of banks. The design of the overall regulatory framework must consider their combined effects, and the balance between capital and liquidity requirements is a central element of prudential policy.