Definition: A reserve requirement, also known as the cash reserve ratio, represents the minimum percentage of customer deposits that a bank should hold as a reserve.
What Does Reserve Requirement Mean?
What is the definition of reserve requirement? A cash requirement is a default risk management policy, employed by the Federal Reserve Bank in the context of its monetary policy to ensure that a strict fraction of customer deposits and notes are held on reserve in the Fed’s vaults.
The Federal Reserve is responsible for determining the percentage of a reserve requirement, and lends its customers based on this percentage, holding a certain amount of money available in cash to cover for customer withdrawals or anticipate a massive withdrawal of deposits that may cause prevent a bank run, thus panicking the rest of the depositors.
Let’s look at an example.
The manager of the General Commercial Bank asks his assistant to prepare a breakdown of the cash requirement to ensure that the bank meets the legal reserve requirements. The assistant finds that at the close of business on September 13, General Commercial Bank has $528,196,740 in deposits, $862,887 in cash and $75,258,732 in the Federal Reserve vault.
Following the reserve requirement of the Federal Reserve, the bank allows a strict percentage of 12% of its deposits to be withdrawn. Therefore, the General Commercial Bank should keep at least $528,196,740 x 12% = $63,383,609 in a Federal Reserve account and not use this amount of money for lending.
Since the General Commercial Bank has $75,258,732 in the Federal Reserve vault it meets the legal reserve requirements.
In fact, the reserve requirement is a policy to ensure the solvency of the financial institutions. To that end, the Federal Reserve determines the percentage of cash reserves and ensures that the banks will have cash available to anticipate a bank run or to prevent it. In the case that a commercial bank cannot meet its legal requirement, the Federal Reserve lends the amount needed to cover the discrepancy.
Define Reserve Requirement: A bank requirement to reserve cash is mandated by the government to protect depositors from the bank loaning out too much of its deposited funds.