What is the Reserve Requirement?

The reserve requirement is the amount of resources that a bank or other financial institution must have on hand in order to offer services like loans or mortgages to their customers. Maintaining a required reserve ratio of this nature was once considered essential to controlling the growth of the money supply within a given nation, although the importance of this function has somewhat diminished over the years. Still, requiring that a bank have access to an amount of reserves that is in proportion to the services it provides to customers helps to increase the security of those transactions, and thus aid in keeping the overall economy within a state of balance.

In most countries, some type of central authority determines the reserve requirement for any bank operation. Depending on the structure of the federal government, reserve requirements may be established and monitored by a central regulatory agency, or by a central bank established by the government. The amount of the reserve is usually a combination of the money that is physically kept within the bank, and the funds that the bank has access to through the central authority, such as the central bank.

The exact amount of the reserve requirement for a specific bank is determined by the amount of deposits that the bank currently holds on behalf of its customer base. Using formulas that vary somewhat from one national banking system to another, the goal is to determine how much in the way of reserves the bank needs in order to balance loan activity with those deposits. Once that figure is determined, then the bank is required to establish and maintain that ratio between deposits and loans, and thus prevent the institution from becoming unstable.

In some quarters, the concept of a reserve requirement is considered obsolete. Reasons for this perception usually include the fact that banks will maintain adequate reserves as part of the strategy for remaining solvent, thus eliminating the need for the capital requirement to be regulated. Others note that the wider variety of financing options available today also undermine the reason for the reserve requirement, while not doing anything to reduce expenses incurred by the bank. At the same time, proponents of the reserve requirement note that unless there is some type of bank regulation by a central authority, banks could conceivably overextend lending activity to the point that it becomes detrimental not only to their customers, but to the general economy as well.