Bank reserves are money that banks hold in their vaults or at the Federal Reserve instead of lending it out to customers
When you deposit money at a bank, the bank does not keep all of it sitting in a vault. It lends most of it to other customers as mortgages, car loans, and business lines of credit. But banks are required to keep a portion of customer deposits on hand at all times. That portion is called a reserve. The amount varies depending on the type of deposit and the bank's size, but it exists to make sure a bank can pay you if you withdraw your money.
Reserves serve two purposes: they protect you as a depositor, and they give the Federal Reserve a tool to control how much money moves through the economy. When the Federal Reserve raises the reserve requirement, banks have to hold more cash and can lend less. When it lowers the requirement, banks can lend more. This is one way the Fed influences whether credit is tight or loose in the country.
Key Takeaways
- Banks must hold a percentage of customer deposits as reserves instead of lending them all out, which protects your ability to withdraw money.
- Reserve requirements are set by the Federal Reserve and vary by deposit type and bank size, though many requirements were eliminated in 2020.
- Reserves sit in the bank's vault or in an account at the Federal Reserve, earning little to no interest for the bank.
- The Federal Reserve uses reserve requirements as a tool to control lending and the money supply in the broader economy.
How reserve requirements work
The Federal Reserve sets the reserve requirement as a percentage of customer deposits. For example, if the requirement is 10 percent and you deposit $1,000, the bank must keep $100 in reserve and can lend out $900. The bank cannot use that $100 for loans, investments, or anything else—it must stay available to cover withdrawals.
In March 2020, the Federal Reserve reduced most reserve requirements to zero percent. This means most banks no longer have a legal minimum amount they must hold in reserve. However, banks still keep reserves voluntarily because they need cash on hand to meet daily withdrawal requests and to satisfy their own risk management practices. A bank that runs out of cash cannot function, even if it has profitable loans on its books.
Where reserves are actually stored
Bank reserves exist in two places. Some sit physically in the bank's vault as cash. Most sit in an account the bank holds at the Federal Reserve itself. When you withdraw cash from an ATM, the bank pulls from its vault. When a large business transfers money to another bank, the sending bank's Federal Reserve account decreases and the receiving bank's increases. The Federal Reserve tracks these transfers electronically throughout the day.
Reserves at the Federal Reserve earn interest, but the rate is very low—often close to zero. This means banks have little financial incentive to hold reserves beyond what they need for safety and daily operations. A bank would rather lend money at 5 percent interest than hold it in a Federal Reserve account earning 0.1 percent. This tension between safety and profit is why banks hold the minimum reserves they think they need, not more.
Why reserves matter to you as a depositor
Reserves protect you in two ways. First, they ensure the bank can pay you when you withdraw money. If everyone at your bank tried to withdraw their deposits on the same day—an event called a bank run—the bank's reserves would be the first money available to pay you. Second, the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per account holder per bank. Reserves are not the only safety net, but they are the first one.
You do not see reserves directly on your account statement. The bank does not tell you "we are holding 10 percent of your deposit in reserve." But reserves affect you indirectly: a bank with healthy reserves can offer you better interest rates on savings accounts and lower rates on loans, because it is not desperate for cash. A bank with weak reserves may tighten lending or raise fees to build cash faster.
How the Federal Reserve uses reserves to control the economy
The Federal Reserve uses reserve requirements as one tool to influence the money supply. When the economy is weak and the Fed wants banks to lend more, it lowers the reserve requirement. Banks can then lend out a larger share of deposits, putting more money into circulation. When inflation is high and the Fed wants to slow lending, it raises the requirement. Banks must hold more cash and lend less, reducing the money supply.
The Fed also influences reserves through the interest rate it pays on reserves held at the Federal Reserve. If that rate is high, banks are incentivized to hold more reserves. If it is low, banks are incentivized to lend more. These tools work together to shape how much credit is available in the economy and how fast money circulates.
The difference between reserves and capital
Reserves and capital are often confused because both relate to a bank's safety. Reserves are money the bank holds to cover withdrawals. Capital is the bank's own money—the equity that shareholders own. If a bank has $100 million in deposits and $10 million in capital, the capital is the cushion that absorbs losses if loans go bad. Reserves are the cash on hand to pay depositors. A bank can have strong reserves but weak capital, or vice versa, though regulators monitor both.
Capital requirements are separate from reserve requirements and are set by banking regulators like the Office of the Comptroller of the Currency (OCC). A bank must maintain a minimum ratio of capital to assets. This is why you sometimes hear about banks being "well-capitalized"—it means they have enough of their own money at stake to absorb losses and keep operating if things go wrong.
What happens when a bank does not have enough reserves
If a bank falls short of its reserve requirement (when one exists), the Federal Reserve can fine the bank or force it to borrow from the Fed's discount window at a penalty rate. If a bank's reserves are so low that it cannot meet withdrawal requests, it becomes insolvent and regulators step in. The FDIC may take over the bank, sell it to another bank, or liquidate it. Your deposits are protected up to $250,000 by FDIC insurance regardless of what happens to the bank's reserves.
Bank failures are rare in the modern era because regulators monitor reserves and capital constantly. Banks file reports to the Federal Reserve and other regulators every quarter. If a bank's reserves or capital fall below safe levels, regulators require the bank to raise more money, cut lending, or merge with a stronger bank before a crisis develops.
Frequently Asked Questions
Do I need to worry about my bank's reserves?
No. The FDIC insures your deposits up to $250,000 per account holder per bank, regardless of how much the bank holds in reserves. You can check a bank's financial health through public reports filed with the Federal Reserve, but for most depositors, FDIC insurance is sufficient protection.
Can banks lend out all their deposits if they want to?
No. Even though most reserve requirements are now zero, banks must still hold enough cash to meet daily withdrawals and satisfy their own risk management standards. Regulators also require banks to maintain minimum capital ratios. A bank that tried to lend out every dollar would quickly run out of cash and fail.
Does the Federal Reserve hold my money?
No. Your money is held by your bank. The Federal Reserve holds the bank's reserves—the portion of deposits the bank is required or chooses to keep on hand. You have a relationship with your bank, not with the Federal Reserve. The Fed is the bank's bank.
Why do banks earn interest on reserves at the Federal Reserve?
The Federal Reserve pays interest on reserves to encourage banks to hold more cash during economic downturns. When the Fed raises the interest rate on reserves, banks are more willing to hold cash instead of lending it out, which slows the economy. When the Fed lowers the rate, banks are incentivized to lend more, which speeds up the economy.
What is the difference between reserves and money supply?
Reserves are the cash banks hold. Money supply is all the money in circulation—cash in wallets, money in checking accounts, and other liquid assets. When banks hold more reserves, they lend less, so the money supply grows slower. When banks hold fewer reserves, they lend more, so the money supply grows faster.