Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Reserve Requirements as a Policy Tool
Transcript
- Lucas: So you've heard of reserve requirements — the fraction of deposits banks are required to keep in their vault or at the central bank. It's one of those tools that sounds like it should be the backbone of modern monetary policy. Luna: And yet, in practice, it's been largely abandoned by the big central banks. The Fed hasn't used it actively since before the global financial crisis. The ECB and Bank of England barely touch theirs. Lucas: Right. But that's actually the interesting part. Reserve requirements are not dead — they've just been repurposed. And in some parts of the world, they're still very much alive. Today I want to trace where they came from, why they fell out of favour, and one case where they're still crucial. Luna: Let's start with the basics. How do reserve requirements actually work in theory? Lucas: In textbook fractional-reserve banking, a bank takes in deposits and lends out most of them, keeping only a fraction as reserves. That fraction is the reserve requirement. It's supposed to limit how much credit the banking system can create. If the central bank raises the requirement, banks have to pull back lending to meet it. Lower it, and they can lend more. Luna: The classic money multiplier. I remember learning that in school. But in reality, it never worked quite so neatly. Lucas: Exactly. The multiplier assumes banks lend every dollar they can, and that borrowers instantly redeposit the money. In real life, banks hoard excess reserves, and money leaks out of the system. Still, for decades, reserve requirements were the primary way central banks influenced credit growth. Luna: When did that start to change? Lucas: The big shift happened after the 2008 financial crisis. Before that, central banks operated in a 'scarce-reserves' framework. They used open-market operations to keep the supply of reserves tight, so that small changes in reserve requirements would nudge the federal funds rate. But after 2008, the Fed embarked on massive quantitative easing — buying trillions of dollars of bonds — which flooded the banking system with reserves. Luna: So all of a sudden banks had way more reserves than they needed to meet requirements. The tool became irrelevant. Lucas: Right. In the new 'ample-reserves' framework, the Fed uses interest on reserves — IOR — as its main lever. It sets the rate it pays banks on their reserves, and that effectively sets a floor under short-term interest rates. Reserve requirements became a burden, not a policy tool. Luna: And eventually, the Fed eliminated them entirely. In March 2020, as part of the pandemic response, they set the reserve requirement ratio to zero. Lucas: That's right. The Fed's official line was that it wanted to free up bank balance sheets to support lending. But really, it acknowledged that reserve requirements were doing nothing useful. The ECB and Bank of England had already moved to minimal or zero requirements years earlier. Luna: But they still exist on paper, don't they? The ECB has a 1% reserve ratio, and the Bank of England has a 0% ratio? Actually, the Bank of England set theirs to zero in 2020 as well. Lucas: Yes, but the ECB still maintains a positive ratio of 1% on certain liabilities. However, they apply something called 'tiering' — they exempt a portion of reserves from the requirement, or even pay a different rate on them. It's more of a regulatory relic than an active policy tool. Luna: So if the big three central banks have abandoned active use, who still uses reserve requirements meaningfully? Lucas: China. The People's Bank of China — the PBOC — still uses its reserve requirement ratio, or RRR, as a primary tool. Over the past few years, they've cut it repeatedly to stimulate the economy. For instance, in 2021 and 2022, they cut the RRR by 50 to 100 basis points at a time, freeing up hundreds of billions of yuan for lending. Luna: Why does it work for China but not for the US? Lucas: Two reasons. First, China's banking system is still dominated by state-owned banks that are more responsive to central bank directives. When the PBOC cuts the RRR, those banks actually increase lending. Second, China hasn't flooded its system with excess reserves the way the Fed did. Their QE programs were much smaller, so reserve requirements still bite. Luna: So it's about context. The tool's effectiveness depends on the structure of the banking system and the level of reserves. Lucas: Exactly. And that's why some economists argue reserve requirements could make a comeback. If a central bank ever wants to tighten quickly while also draining reserves — say, after a massive QE program — raising reserve requirements could be a complement to quantitative tightening. Luna: But wouldn't that be seen as a blunt instrument? Banks might cut lending abruptly, causing a credit crunch. Lucas: It is blunt. That's the downside. Which is why most central banks now prefer interest on reserves and other fine-tuning tools. Reserve requirements are more like a sledgehammer. But sometimes you need a sledgehammer — especially if you're trying to rein in a housing bubble or hot lending growth. Luna: Are there any other central banks that still use reserve requirements actively today? Lucas: Several. The Reserve Bank of India uses a cash reserve ratio, currently at 4.5%. Brazil's central bank has a high required reserve ratio — over 20% on demand deposits. Turkey has used reserve requirements as part of its unorthodox toolkit. So it's not just emerging markets; even some developed economies like New Zealand have considered using them as a macroprudential tool. Luna: Macroprudential — meaning to cool down a specific sector, like housing, rather than the whole economy. Lucas: Exactly. The Bank of England has talked about using a 'countercyclical capital buffer' for similar ends, but reserve requirements could also serve that purpose. For instance, you could impose a higher reserve ratio on banks that are heavily exposed to mortgage lending, to discourage that activity. Luna: That's a clever idea. But wouldn't banks just find a way around it? Like moving deposits off their balance sheet? Lucas: They would try. Regulatory arbitrage is always a concern. That's why any reserve requirement regime has to be carefully defined — what counts as a reservable liability, whether certain instruments are exempt, and so on. But the same issue applies to any regulation. Luna: So what's the bottom line for listeners? Should we expect reserve requirements to come back in the US or Europe? Lucas: I doubt they'll return as a primary tool. The ample-reserves framework is too entrenched, and IOR is simply more precise. But I could see them being used in a crisis scenario — say, if the Fed ever needed to absorb reserves quickly and didn't want to rely solely on reverse repos or bill issuance. It's a tool in the toolbox, even if it's rusted. Luna: And for investors or anyone watching central bank policy, it's worth keeping an eye on changes to reserve requirements in countries like China or India. Those moves can have real effects on credit growth and, ultimately, on global markets. Lucas: Absolutely. A 50-basis-point cut in China's RRR might not make headlines in the West, but it can release over a trillion yuan into the banking system. That's not nothing. Luna: Speaking of things that don't always make headlines but matter — I want to take a quick moment to mention something that keeps this show going. We don't run ads, and that's a deliberate choice. It means we can talk about tools like reserve requirements without having to sell you anything. Lucas: And we want to keep it that way. The way to do that is through listener support. If you've been following along with these episodes and you've gotten something out of them — maybe you've finally understood how central banks actually work — there's a simple way to help. Luna: It's buy me a coffee dot com slash fexingo. That's all one word, no spaces. Buy me a coffee dot com slash fexingo. Even a one-time contribution helps us pay for hosting and research. No pressure, just an option if you value what we do. Lucas: Right. And now, back to reserve requirements. One last angle I want to touch on: the historical link between reserve requirements and the gold standard. Luna: How so? Lucas: Before the gold standard was abandoned, central banks often required banks to hold a certain percentage of their deposits in gold or gold-backed currency. That was the original reserve requirement. It was a way to ensure convertibility. When countries left gold, they replaced gold reserves with central bank reserves. But the concept survived. Luna: So the modern reserve requirement is essentially a remnant of the gold standard era? Lucas: In a way. But it's also been adapted. Today, the requirement is usually satisfied by holding balances at the central bank, not gold. And central banks can change the ratio without worrying about gold outflows. That's both a strength and a weakness — it gives them flexibility, but also removes the discipline that gold backing imposed. Luna: Which brings us back to the debate about whether reserve requirements should be used more aggressively. Some economists argue that a higher reserve ratio would make the banking system more stable, by forcing banks to hold more safe assets. Lucas: It's a valid argument. Higher reserve requirements reduce the risk of bank runs, because banks have more liquidity on hand. But they also reduce profitability, because banks can't lend out as much. It's a trade-off between stability and credit creation. The optimal level depends on the economic environment. Luna: And on the central bank's credibility. If the central bank is seen as strong, maybe you don't need high reserve requirements as a safety buffer. Lucas: Exactly. That's why Switzerland's central bank, the SNB, has a very low reserve requirement — just 2.5%. And they haven't changed it in decades. They rely on other tools. Meanwhile, the PBOC adjusts its RRR frequently, because they see it as a flexible tool. Luna: So reserve requirements are a bit like a dial that some central banks turn and others leave in one position. Lucas: Good analogy. And the key takeaway is that just because the Fed has dialed it to zero doesn't mean it's irrelevant. For investors, the countries that still use this dial are places where credit cycles can be strongly influenced by central bank decisions on reserve ratios. If you're looking at China, India, or Brazil, the RRR is a number to watch. Luna: Makes sense. Next time we see a headline about the PBOC cutting the RRR, we'll know exactly what that means. Lucas: And why it matters. So that's reserve requirements — an old tool, still in use, still powerful in the right context. Next episode, we'll look at another tool that's often misunderstood: standing lending facilities. Luna: Looking forward to it.