'Reserve Requirement' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
The reserve requirement proves to be the quantity of funds which banks are required to hold on hand each and every night. This is expressed as a percentage of the bank’s total demand deposits. A country’s central bank is responsible for setting out the effective percentage rate.
Within the United States, it is up to the Federal Reserve’s Board of Governors to determine the member banks’ reserve requirements. Such a requirement is applicable for commercial banks, savings and loan associations, savings banks, credit unions, Edge corporations, U.S. based branches or agencies of foreign banks, and agreement corporations.
The banks are allowed to keep their cash physically within their proprietary on-site vaults or keep them deposited with their area Federal Reserve Bank. When banks lack sufficient cash to fulfill their reserve requirements, they are able to borrow cash from other banks with extra to spare. They could also obtain a loan from the discount window of the Federal Reserve alternatively. Money which banks lend or borrow from one another in order to meet their own requirements is called the Federal funds.
Among the many tools which the Fed counts at its disposal, the reserve requirement is the underlying basis for all of them. They are able to employ this to precisely control cash liquidity within the economy. Smaller reserve requirements prove to be expansionary types of monetary policy. This is because they permit a greater amount of money to flow through the banking system into the real economy. Higher reserve requirements conversely are contractionary. They soak up money from the pool of available liquidity and tamp down on economic activities.
It is also true that the greater a reserve requirement is, the smaller the profits will be for a bank deploying its customers’ money. Higher requirements are particularly challenging for smaller banks. This is because they begin with a smaller pool from which to lend out money. Because of this reality on the ground, small banks are usually exempted from such onerous requirements. Smaller banks are those which have fewer deposits than $12.4 million.
The Fed does not often actually change the reserve requirement. This is because it is expensive to do so. Banks are forced to rectify their policies to compensate when this is done. Because of this, the board avoids changing the requirements on its member banks. It is far easier for them to tweak the amounts of deposits which are subjected to the various reserve requirements every year.
For example, since October 12, 2012, the Federal Reserve has mandated that every bank possessing greater than $79.5 million in deposits must keep a minimum reserve amount of 10 percent of total deposits. Those banks which count under $79.5 million but still greater than $12.4 million only have to keep three percent of deposits on hand. Again those banks with fewer than $12.4 million in deposits fall under the pre-determined exemption amount. They enjoy a zero percent reserve requirement.
The Federal Reserve does raise the levels of deposits which are subject to its various ratios each year. This provides the banks with an incentive to become larger. From June 30 to June 30, the Fed is able to raise its low reserve tranche and accompanying exemption amount by 80 percent of the amount that deposits increase in the previous year.
Deposits which are considered for these reserve requirements include a number of different types. These are automatic transfer service accounts, demand deposits, NOW accounts, telephone or authorized transfer accounts, share draft accounts, ineligible bankers’ acceptance, and affiliate-issued obligations which mature in seven or fewer days. Banks are only required to accept the net amount. They are not expected to cover any amounts owed to them by other banks or any cash that remains outstanding. As of December 27, 1990, deposits do not comprise Euro-currency liabilities or non personal time deposits.
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