The purpose of bank reserves is to reduce the likelihood of widespread panic if a bank finds itself unable to have sufficient cash to satisfy customers' withdrawal requests. On the other hand, the Federal Reserve will meet unanticipated demands via short-term and overnight borrowing.

All institutions that accept deposits must comply with the standards for bank reserves. Financial institutions such as commercial banks, savings banks, savings and loan organizations, credit unions, U.S. branches and agents of foreign banks, Edge companies, and agreement corporations are included in this category. Regulation D mandates that businesses keep their reserves either in cash in a secure room on the premises or as a deposit with a Federal Reserve branch in the neighborhood.

The Functioning of Bank Reserves

Imagine the following scenario: you go to the bank to withdraw cash, but the cashier tells you there is insufficient cash on hand to complete your request and that your withdrawal has been refused. The reason for the existence of bank reserves is to guarantee that circumstances such as these will never occur.

In addition, reserves are used as a tool in the process of helping to boost the economy. Imagine that a financial organization has 20 million dollars in deposits. Suppose the Federal Reserve requires that particular institution to hold 3% of its money in its bank reserves (which would be $600,000). In that case, that institution is free to lend out the other $19.4 million in the form of mortgages and other loans. Families can purchase houses, children can save money for college, and more individuals can purchase automobiles, yachts, and other luxury items.

The importance of bank reserves lies in that financial institutions may earn interest on their capital by lending it out to customers rather than keeping it in reserve at the Federal Reserve. Without stored reserves, financial institutions risk being persuaded to give out more money than they should. A bank's reserves are included as an asset on the institution's annual report. If a bank cannot satisfy the reserve requirement, it can borrow money at the bank rate from either another bank or the Federal Reserve.

Bank Reserve Requirement

Federal Reserve Board of Governors is responsible for determining bank reserve requirements, sometimes called the bank reserve ratio. This requirement applies to all depositories in the United States and is computed as a percentage of the bank's total deposits.

The reserve requirement was reduced to zero by the Federal Reserve on March 26, 2020, to encourage financial institutions to increase the amount of money they lend to families that have been adversely affected by the epidemic. As of October 2021, it is still in force. Before this modification, the minimum reserve requirement for a bank may be anything from 3% to 10% of the bank's total net transaction account balance. It was necessary that any bank with assets more than $127.5 million set aside 10% of such assets.

Federal Reserve System

Before the introduction of bank reserves, financial institutions had a terrible reputation for not maintaining sufficient cash. Customers of other banks would likely panic and withdraw their cash if one of their banks closed, leading to a chain reaction of bank runs. In December 1913, Congress decided to develop a more reliable and secure monetary system by establishing the Federal Reserve System to achieve this goal.

Following the devastating effects of the Great Depression, Congress enacted the Banking Act of 1933, which led to the Federal Deposit Insurance Corporation (FDIC) formation. The Federal Open Market Committee (FOMC), which serves as the decision-making body for the Federal Reserve's monetary policy, was established by the Banking Act of 1935.

In the years leading up to the global financial crisis of 2008, financial institutions did not receive any interest on deposits they kept with their regional Federal Reserve bank. This was altered on October 1, 2008, with the passage of the Emergency Economic Stabilization Act, which authorized the Federal Reserve to pay interest on excess reserves held by qualifying institutions. This was a significant departure from the previous situation.

One of the four instruments used to implement monetary policy is the interest on reserve balances (IORB) rate, which the Board of Governors determines. Since July 29, 2021, the interest rate offered by the IORB has been 0.15%. This indicates that a bank receives an interest payment of $1,500 for every million dollars deposited into a reserve account.