Table of Contents
SERIES 65 | FINANCIAL REGULATION COURSES
Reserve requirements are regulations specifying the minimum amount of funds that depository institutions — commercial banks, savings institutions, credit unions, and branches of foreign banks operating in the United States — must hold in reserve against specified deposit liabilities, either as vault cash or as balances maintained in their accounts at Federal Reserve Banks. Historically one of the three primary tools of Federal Reserve monetary policy alongside open market operations and the discount rate, reserve requirements were eliminated in the United States effective March 26, 2020, when the Federal Reserve Board reduced reserve requirement ratios to zero percent for all depository institutions — a structural change that fundamentally altered the operating framework of United States monetary policy and that every candidate studying for the Series 65 examination must understand alongside the historical framework that preceded it.
The authority for the Federal Reserve to impose reserve requirements derives from the Federal Reserve Act, which authorises the Board of Governors to establish reserve requirements within specified statutory ranges for purposes of implementing monetary policy on certain types of deposits and other liabilities of depository institutions. Regulation D — Reserve Requirements of Depository Institutions, codified at 12 CFR Part 204 — is the implementing regulation through which the Federal Reserve Board historically administered reserve requirements.
The Monetary Control Act of 1980 — formally the Depository Institutions Deregulation and Monetary Control Act — significantly expanded the Federal Reserve's reserve requirement authority by extending it to all depository institutions, not merely Federal Reserve member banks. Prior to 1980, non-member state-chartered banks were not subject to Federal Reserve reserve requirements, creating a competitive disadvantage for member banks that had to hold non-interest-bearing reserve balances while non-members had no such obligation. The Monetary Control Act eliminated this disparity and brought all federally insured depository institutions within the reserve requirement framework.
Under the pre-2020 framework, reserve requirements were imposed on transaction accounts — checking accounts and similar demand deposit accounts from which funds can be withdrawn by negotiable order or on demand. The reserve requirement ratio on net transaction deposits above the low reserve tranche amount was ten percent — meaning a bank with one hundred million dollars in qualifying transaction account balances above the tranche threshold was required to hold ten million dollars in required reserves at all times. The low reserve tranche amount — approximately sixteen million dollars before the 2020 elimination — was subject to a three percent reserve ratio, and amounts below the reserve requirement exemption amount were exempt from any reserve requirement entirely.
Non-personal time deposits — certificates of deposit held by non-individuals — and Eurocurrency liabilities were historically subject to reserve requirements under the Federal Reserve Act's authority, though these requirements were set at zero percent for extended periods prior to the 2020 elimination.
The distinction between required reserves and excess reserves was foundational to understanding how the pre-2020 Federal Reserve monetary policy framework operated.
Required reserves were the minimum balances a bank was obligated to maintain — calculated by applying the reserve requirement ratio to the bank's average daily balance of reservable liabilities over the two-week reserve maintenance period. Banks that ended a maintenance period with insufficient reserves were required to pay a penalty or obtain additional reserves.
Excess reserves were balances held at Federal Reserve Banks above and beyond the required amount. Prior to 2008, because the Federal Reserve did not pay interest on reserve balances, banks had strong incentives to minimise excess reserves — holding idle non-interest-bearing balances represented an opportunity cost relative to lending those funds in the federal funds market or deploying them in other interest-earning activities. Banks with reserve surpluses lent overnight to banks with reserve deficits in the federal funds market — the overnight interbank lending market whose rate the FOMC targeted as its primary monetary policy instrument.
The interplay between required reserve balances and the federal funds market created the transmission mechanism through which the FOMC's reserve-supplying or reserve-draining open market operations affected the federal funds rate. By adding or withdrawing reserves through Treasury security purchases and sales with primary dealers, the FOMC influenced whether the marginal bank in the federal funds market was a net borrower or net lender, pushing the rate toward the FOMC's target.
The Emergency Economic Stabilization Act of 2008 granted the Federal Reserve authority to pay interest on reserve balances — both required reserves and excess reserves — beginning immediately rather than waiting until the originally scheduled 2011 date. This authority, exercised beginning October 9, 2008, fundamentally transformed the relationship between reserve requirements and monetary policy implementation.
Interest on required reserve balances — IORR — eliminated the implicit tax that reserve requirements had previously imposed on banks by forcing them to hold non-interest-bearing balances against deposits. Interest on excess reserve balances — IOER — gave the Federal Reserve a powerful new tool — setting the IOER rate above money market rates incentivised banks to park excess reserves at the Federal Reserve rather than lending them out, providing a tool to prevent the massive reserve injections from quantitative easing from translating into proportional money supply expansion.
With the Federal Reserve paying interest on reserves, the IOER rate effectively became the floor for overnight money market rates — no bank would lend overnight in the federal funds market at a rate below what it could earn risk-free by holding reserves at the Federal Reserve. The federal funds market shrank dramatically as banks accumulated massive excess reserves from quantitative easing, and the FOMC shifted from targeting a specific rate through reserve scarcity to maintaining a rate corridor bounded below by the IOER rate and above by the discount rate.
On March 15, 2020 — one of the Federal Reserve's extraordinary actions in response to the COVID-19 pandemic and its economic consequences — the Federal Reserve Board announced that reserve requirement ratios would be reduced to zero percent for all depository institutions, effective March 26, 2020. This action eliminated required reserves entirely, reducing required reserve balances by an estimated two hundred billion dollars.
The elimination of reserve requirements reflected the Federal Reserve's recognition that in an ample-reserves operating environment — where banks hold large quantities of excess reserves above any regulatory minimum — reserve requirements had ceased to serve a meaningful monetary policy implementation function. With reserve balances vastly exceeding any reserve requirement that might exist, the reserve requirement constraint was economically irrelevant — no bank was close to its minimum required balance. The FOMC controlled the federal funds rate through the interest on reserve balances rate and the overnight reverse repo facility rate rather than through manipulating reserve scarcity.
The Federal Reserve simultaneously simplified reserve balance terminology following the 2020 elimination. Interest on required reserve balances and interest on excess reserve balances were merged into a single interest on reserve balances rate — IORB — effective July 29, 2021, recognising that the distinction between required and excess reserves had no practical meaning after the elimination of reserve requirements.
The traditional textbook explanation of how reserve requirements affected the money supply operated through the money multiplier — the mechanism by which initial deposits expand through the banking system as each bank lends out the portion of deposits not required to be held in reserve.
In the simple money multiplier model, a ten percent reserve requirement produced a money multiplier of ten — one hundred dollars of new deposits could support one thousand dollars of broad money supply as each successive bank received deposits and lent out ninety percent. A reduction in the reserve requirement ratio expanded the multiplier and the potential money supply. An increase contracted it.
This textbook model significantly overstates the mechanical precision of the reserve requirement-money supply linkage in practice. Banks do not automatically lend every dollar of excess reserves — lending depends on creditworthy borrower demand, risk appetite, capital adequacy, and regulatory constraints. The money multiplier is more accurately viewed as a ceiling on money supply expansion than as a predictable transmission mechanism. The Federal Reserve itself has moved away from the textbook money multiplier framework in describing how monetary policy actually works, emphasising instead the role of interest rates, credit conditions, and bank capital in determining actual lending volumes.
With reserve requirements eliminated, the Federal Reserve now operates an ample-reserves framework — the FOMC controls the federal funds rate by setting the interest on reserve balances rate and the overnight reverse repo facility rate as the floor and corridor for overnight money market rates rather than through scarcity management of reserve quantities.
This framework is more transparent and operationally simpler than the pre-2008 scarce-reserves framework — the federal funds rate does not jump to the IOER rate or OFN RRP rate as in a strict floor system, but moves within a narrow corridor between the two. The Federal Reserve continues to hold a large balance sheet from quantitative easing programmes, maintaining the abundance of reserves that makes the ample-reserves framework viable. A return to a scarce-reserves operating framework — and the potential reimposition of meaningful reserve requirements — would require a substantial reduction in the Federal Reserve's balance sheet that would take years to accomplish.
Reserve requirements are tested on the Series 65 examination in the context of Federal Reserve monetary policy tools, the banking system, and the historical framework through which the money supply was influenced.
The key points to retain are these.
Reserve requirements historically required depository institutions to hold a minimum percentage of deposit liabilities as vault cash or Federal Reserve balances, implemented through Regulation D at 12 CFR Part 204 under Federal Reserve Act authority. The Monetary Control Act of 1980 extended reserve requirements to all depository institutions, not only Federal Reserve member banks. Under the pre-2020 framework, the primary reserve ratio was ten percent on net transaction accounts above the low reserve tranche, with three percent on balances within the tranche and zero on amounts below the exemption threshold.
Required reserves were the regulatory minimum. Excess reserves were balances above the minimum — prior to 2008 these were minimised because they earned no interest, and banks lent excess balances in the federal funds market whose rate the FOMC targeted through open market operations. The Emergency Economic Stabilization Act of 2008 authorised the Federal Reserve to pay interest on reserve balances beginning October 9, 2008 — transforming monetary policy implementation from a scarce-reserves framework to an ample-reserves framework in which the interest on reserve balances rate became the primary rate-setting tool. The Federal Reserve eliminated reserve requirements entirely effective March 26, 2020, reducing required reserves by an estimated two hundred billion dollars, recognising that reserve requirements had become economically irrelevant in an environment of abundant excess reserves. Interest on required and excess reserve balances was merged into the single interest on reserve balances rate — IORB — effective July 29, 2021. The traditional money multiplier model — under which a ten percent reserve ratio produced a multiplier of ten — is a textbook simplification that significantly overstates the mechanical precision of reserve requirement effects on money supply, as actual lending depends on borrower demand, bank capital, and risk appetite rather than reserve availability alone.
