According to the Congressional Research Service, financial institutions that take in demand deposits are required under the Federal Reserve Act of 1913 to put aside reserves--safe and secure assets--in certain fractions against deposits. Originally, these requirements were intended to guarantee liquidity during periods of financial strain and to minimize domino effects from bank runs on other banks. As the lender of last resort, the Federal Reserve was therefore created to meet liquidity needs for the banking system during such times.
The primary function of the legal reserve requirement is to prevent depository institutions from lending out more of their reserves than is wise and thereby imperil solvency, as well as customer deposits. While the Federal Deposit Insurance Corporation (FDIC) safeguards customer deposits, state and federal examinations make certain that banks stay solvent.
As the financial system has developed over the past 100 years, the rationale behind the reserve requirement has changed from providing a guaranteed source of liquidity during times of crisis to serving as an auxiliary tool of monetary policy by the Federal Reserve, reports Stuart E. Weiner of the Federal Reserve Bank of Kansas City. By regulating the fraction of liquid assets that the bank must hold in reserve, the Federal Reserve manages the nation’s money supply. While a hike in reserve requirements will constrict money supply, a lower requirement will have the opposite effect. In real-world practice, the Board of Governors rarely changes the legal minimum reserve requirement. Even wee adjustments in reserves can have an unintended, widespread impact on the banking system.
Buying and selling government securities in the secondary market by the Federal Reserve is known as open market operations. Purchase of securities boosts the money supply and eases the availability of credit. The sale of securities has the opposite effect. By using the reserve requirement to guarantee a predictable and reliable demand for reserves, the Federal Reserve is better able to not only manage market conditions, but also limit disruptions in the money market, according to Joshua N. Feinman, of the Federal Reserve Board’s Division of Monetary Affairs.
The proportion of deposits held by banks in reserve as either non-interest-bearing reserve balances with the Federal Reserve or vault cash imposes a cost that equals the amount of foregone interest. While the Federal Reserve Board has been in support of proposed legislation that would pay interest on reserve balances, opposition has stressed that such measures would negatively impact Treasury revenue.