Reserve requirement

A reserve requirement is imposed by regulators (usually central banks) on banks. It is a proportion of deposits that must be held by a bank rather than being lent to borrowers.

The reserve requirement is usually held in a bank's account with the central bank.

The main purpose of the reserve requirement is to control growth in the money supply.

The reason banks increase the money supply is that they lend the money deposited with them, but most of this is then redeposited in the banking system. For example if you deposit money in a current account, your bank can (and will) then lend it. At the same time, you can still write a cheque against it.

Banks can thus create money in the form of bank balances, but the reserve requirement can act as a brake on the process by preventing banks from lending as much as they might. Because of the iterative nature of this process a small change in the reserve requirement can have a large effect on the money supply.

A reserve requirement is usually a single digit percentage, resreve requirements have tended to fall over the years as developments such as the growth of eurocurrency markets have made them less effective as a policy tool to control the money supply.