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 a reserve requirement is to control growth in the money supply, but, as explained below, its importance has diminished over the years. A reserve requirement is usually a single digit percentage
Less importantly, a higher reserve requirement reduces the money multiplier effect of bank lending. This makes the monetary base larger as a proportion of the broad money supply. This means that a larger monetary base is needed to achieve the same quantity of broad money supply. This justifies a bigger monetary base and increases seigniorage profits
Controlling 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.
Abandoning reserve requirements
Reserve requirements have tended to fall over the years because the effectiveness of reserve requirements have been questioned. Banks have found methods for circumventing them. Some countries (including the UK and Canada) have eliminated reserve requirements altogether or lowered them to negligible levels. This appears to have worked well. Their reasons include:
- Banks have found ways of circumventing reserve rquirements. Banks in the US commonly sweep money overnight from accounts that are subject to a reserve requirement to accounts that are not. This is the sort of thing that is called “financial innovation”.
- The extra cost increases costs to banks compared to other ways of financing debt, distorting the market.
- Banks maintain a certain level of reserves for transactions anyway.
- It is possible to meet the same ultimate objectives through open market operations.