Reserve Requirement(Banking) Law and Legal Definition

Reserve requirement is the amount of deposits that a bank must keep on hand at all times. It is the liquid asset held in cash or deposit by a federal reserve system member bank. Reserve requirement is usually a specified percentage of banks' demand deposits and time deposits. Reserve requirement is also known as reserve ratio. Reserve requirement sets the minimum reserves each bank must hold to customer deposit and notes. The board of governors has sole authority over changes in reserve requirements. A member institution holds reserves in the form of vault cash or deposits with Federal Reserve Banks. Central bank is the regulator imposing reserve requirement.

The main purpose of a reserve requirement is to control growth in the money supply. Federal reserve uses reserve requirement as a tool to control liquidity in the market. A low reserve requirement allows more money in the banking system. A high reserve requirement allows less liquidity. Less liquidity slows down economic activity. A small change in the reserve requirement has a large effect on money supply.