Legal Definitions - required reserve

A required reserve refers to the minimum amount of funds that a commercial bank must hold in its vaults or at a central bank, rather than lending out or investing. This requirement is set by the country's central bank and is typically a percentage of the bank's total deposits. The primary purposes of required reserves are to ensure that banks maintain sufficient liquidity to meet customer withdrawals and to allow the central bank to influence the money supply and credit availability in the economy.

• Example 1: Managing New Deposits

  Imagine City Bank receives $50 million in new customer deposits over a week. If the central bank has set a 10% required reserve ratio, City Bank must hold $5 million (10% of $50 million) either in its own vault or as a deposit with the central bank. The remaining $45 million can then be used for making loans to customers or for other investments. This illustrates how a specific portion of a bank's incoming funds is legally mandated to be kept in reserve, directly limiting the amount available for lending.

• Example 2: Impact of Policy Changes

  Suppose the central bank decides to increase the required reserve ratio from 5% to 8% for all banks, aiming to slow down inflation by reducing the money supply. Rural Credit Union currently holds $100 million in deposits. Before the change, it had to keep $5 million (5% of $100 million) in reserve, leaving $95 million available for lending. After the increase, it must now hold $8 million (8% of $100 million) in reserve. This means Rural Credit Union suddenly has $3 million less available for new loans, demonstrating how changes in the required reserve directly impact a bank's lending capacity and the overall availability of credit in the economy.

• Example 3: Addressing a Shortfall

  Coastal Savings Bank experiences an unexpected surge in customer withdrawals, causing its actual cash reserves to fall below the legally mandated required reserve for its current deposit levels. To comply with the law, Coastal Savings Bank must quickly acquire additional funds to meet its required reserve. It might borrow money from other banks that have excess reserves (often in a short-term interbank lending market) or, as a last resort, borrow directly from the central bank. This scenario highlights the legal obligation banks have to maintain their required reserves and the mechanisms they use to ensure compliance, preventing them from operating with insufficient liquidity.