Definition
The reserve requirement is a rule, set by the central bank, specifying the minimum share of deposits a commercial bank must keep in reserve, either as cash in its vault or as deposits at the central bank. The rest may be lent out.
It is a tool of monetary policy and banking regulation. A higher requirement forces banks to hold more idle funds; a lower one frees more money for lending.
Why it matters
How it works
In fractional-reserve banking, a bank lends out most of each deposit, the borrower spends it, and the funds are redeposited elsewhere, ready to be lent again. The reserve requirement caps this process by fixing how much must be held back at each step.
A lower requirement means a larger money multiplier and more credit creation; a higher one tightens credit. In practice many central banks have shifted to managing interest rates and reserve balances directly, so the reserve requirement has become a less central instrument.