Reserve Requirements Went to Zero and the Textbooks Did Not Notice
The rule requiring banks to hold a proportion of deposits at the central bank was a cornerstone of monetary textbooks. Several countries abolished it without consequence.
What They Were
A reserve requirement obliges a bank to hold reserves at the central bank equal to a specified proportion of its deposits.
The traditional rationale was twofold: ensuring banks held liquid assets against withdrawals, and providing the central bank with a lever over lending, since a higher requirement was thought to restrict how much banks could lend.
The second rationale assumed the money multiplier operated. If reserves constrain lending, the requirement is a control. If they do not, it is a tax.
The Abolition
The United States reduced reserve requirements to zero in March 2020. Several other jurisdictions, including Canada, the United Kingdom, Australia, and New Zealand, had abolished them considerably earlier.
The predicted consequence, under the textbook framework, would be unlimited lending expansion. Nothing of the kind occurred.
Lending continued to be determined by capital requirements, credit demand, and risk appetite, exactly as it had been before. The requirement had not been the constraint, so removing it changed nothing.
Why They Stopped Working as a Tool
| Reason | Effect |
|---|---|
| Capital became the binding constraint | Reserves irrelevant to lending capacity |
| Abundant reserves after QE | Banks held far more than required anyway |
| Requirement acted as a tax | Encouraged activity outside the perimeter |
| Better tools existed | Interest on reserves controls rates directly |
The tax point deserves emphasis. Where required reserves earned no interest, the requirement was a levy on deposit taking. That encouraged funding through instruments not subject to it, pushing activity toward the non bank sector, which is the opposite of what a prudential rule should do.
What Replaced Them
Modern implementation of monetary policy operates through interest rates rather than quantities.
Paying interest on reserves sets a floor under short term market rates, since no bank will lend below what it can earn risk free at the central bank. Adjusting that rate moves the whole structure of short rates without needing to control any quantity.
This is the floor system, and it works with abundant reserves, which is convenient because quantitative easing created abundant reserves.
The previous corridor system operated with scarce reserves and required the central bank to fine tune supply daily to keep the rate near target. The floor system is considerably simpler to operate.
Where They Still Exist
Many emerging market central banks retain meaningful reserve requirements and use them actively.
The reasons differ from the textbook rationale. They function as a macroprudential tool to lean against credit growth, as a way to manage the effect of capital inflows, and as a revenue source where reserves are unremunerated.
China in particular has used the required reserve ratio as an active policy instrument, adjusting it frequently to influence credit conditions.
What the Episode Demonstrates
The disappearance of reserve requirements from major systems, with no observable consequence, is about as clean a test as monetary economics offers.
If the money multiplier described how banking worked, abolishing the requirement should have produced a dramatic result. It produced nothing, because banks were never lending out reserves in the first place.
Textbooks have been slow to update, which is why the multiplier is still widely taught and widely believed by people who have not looked at what central banks actually do.
The Bottom Line
Reserve requirements were the mechanism behind the money multiplier, and their abolition in several major economies changed nothing about lending, which is strong evidence the multiplier was never operating. Policy now works through interest on reserves setting a floor under short rates. Emerging markets retain the tool for macroprudential and revenue reasons rather than for the reason the textbooks give.