Reserve requirements refers to the amount of money that a financial institution such as a bank must hold in reserve against deposits and notes made by the institution’s customers. Sometimes referred to as required reserves, these amount of the funds that must be held in reserve will vary, depending on the requirements put in place by the governmental agency responsible for overseeing and regulating the activity of banks within a particular nation. The idea behind reserve requirements is to increase the chances of banks remaining financially stable, even when the general economy experiences some type of prolonged downturn.
In terms of maintaining funds on hand, reserve requirements may be physically held in the vault of the local bank or branch, or be held in the closest location of a central or federal bank that is operated by the national government. When those funds are held in the national bank, they are earmarked for specific financial institutions and may be called upon when and as needed. While there are instances of governments changing reserve requirements from time to time, those minimum amounts typically remain constant from one year to the next.
There are nations in which reserve requirements are utilized as a financial tool to aid in stabilizing the general economy. For example, a government's central bank may shift the required reserves in response to an economic situation like recession or inflation. Before making any change in the reserves, economists usually look closely at the most likely outcome of implementing the shift, both in terms of how it will affect different industries and their consumers, and what the move would do to the liquidity of the banks operating in that nation. This means that governments tend to be slow in making any changes to reserve requirements until it is clear that doing so will result in the desired effect.
The actual reserve requirements for a given bank or financial institution will often vary, based on the amount of deposits held by that institution. Many nations determine the amount of requirements based on what is known as a reserve ratio. This simply means that the bank must hold reserve requirements that are at least a specific percentage above the total amount of transaction deposits, zero on time deposits, and any other type of deposits that may apply.
For example, if a customer deposits a total of $200 US Dollars (USD) in a given bank, that bank may extend a loan in the amount of $180 USD. This simple strategy goes a long way toward keeping banks liquid at all times, since the institution cannot write loans for more than the total amount of funds available to that institution. Doing so means that even if some debtors default on those loans, the institution is likely to remain stable, and depositors can trust their money is safe and accessible at any point in time.