Why do central banks set a reserve requirement?

One of the mechanisms used by most central banks to further this objective is to set a reserve requirement to ensure that banks have, in normal circumstances, sufficient cash on hand in the event that large deposits are withdrawn, which may precipitate a bank run.

What are reserve requirements?

Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the central bank on the basis of a specified proportion of deposit liabilities of the bank.

What is a reserve requirement ratio?

Reserve Requirement = Reserve Requirement Ratio × Deposit Amount For example, if a bank has received $100,000 in deposits and the reserve requirement ratio is set at 5.0%, the bank must maintain a minimum cash balance of $5,000 on hand. Banks can borrow money to meet their reserve requirements at the end of each day.