Concept
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The second, and arguably most important regulatory role played by central banks is to control reserve requirements. Reserves refer to the percentage of commercial bank deposits that the banks must maintain with the central bank at a given time, i.e. the percentage of their clients’ deposits that must be deposited with the central bank.
One of the ways in which central banks can control interest rates is by controlling the amount of capital that must be held in reserve. This is because a central bank can raise interest rates by increasing the reserve requirements for commercial banks. Increased reserves, in turn, mean that commercial banks will have less cash to lend out, in essence creating a shortage in the monetary supply that causes the interest rate to rise due to the effect decreased supply and increased demand has on price. This function is so integral to central banks’ operations that many central banks are known as ‘reserve banks’.