In most countries, the central bank of the country, such as the Federal Reserve in the US, place reserve requirements in the form of cash reserve ratios on the commercial banks. Under the reserve requirements, each commercial bank is required to hold a certain portion of funds collected as deposits in the form of reserves. These required reserves are either stored as cash in the bank’s vault or they are deposited with the central bank.

The central bank uses the reserve ratio to decide how much reserves should be kept. The reserve ratio is the portion of the deposits that the bank has with it. For example, if the bank has $100 million deposits, and it has $15 million currently with it, then the reserve ratio is 15%. This reserve ratio should be above the required reserve ratio as stipulated by the central bank. The bank can lend out the balance money in the form of loans to the public or use it for other purposes. So, in this example, the bank can loan out $85 million.

In the US, the Federal Reserve determines the reserve requirement by specifying the reserve ratio in Regulation D and it is applied to the bank’s reservable liabilities. The reservable liabilities include net transaction accounts, nonpersonal time deposits, and eurocurrency liabilities.

At the time of this writing, the reserve requirements are as follows. The reserve ratio for nonpersonal time deposits and Eurocurrency liabilities is zero, i.e., no reserve is required to be kept against them.

Total transaction accounts consist of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturing in seven days or less. Net transaction accounts consist of total transaction accounts less amounts due from other depository institutions and less cash items in the process of collection. For net transaction accounts upto $12.4 million, the reserve requirement is zero. For accounts above $12.4 million and below $79.5 million it is 3 % and for above $79.5 million it is 10%.

The central bank uses the reserve ratio as an effective monetary policy tool. When it wants to reduce the money supply, or lower the credit in the economy, it increases the reserve requirement, due to which there are less funds available with the banks to lend out to people. However, banks prefer to use open market operations over altering the reserve requirements because it can create immediate liquidity problems for the financial institutions.