A statutory reserve is an amount of cash a financial institution, such as a bank, credit union, or insurance company, must keep on hand to meet the obligations incurred by virtue of accepting deposits and premium payments. The statutory reserves required of banks and credit unions are generally set by the nation's central bank, and those required of insurance companies are set by statute or regulation by the national, state or provincial government or regulatory authority. Calculated in various ways, statutory reserves are required to ensure that financial institutions are capable of paying claims even in a calamitous situation.
Financial institutions like banks, credit unions and insurance companies derive their profits from the loans and investments they make with the funds that have been deposited with them. Other financial institutions, like brokerages, make their profits by charging their clients commissions on each transaction, and don't generally have access to their clients' funds for lending or investing, and thus are usually not subject to reserve requirements.
Banks, credit unions and insurance companies, then, must strike a balance between their obligation to their shareholders to maximize profits by investing and lending their assets — the deposits and premiums they've accepted — and their obligation to their depositors and clients to maintain enough liquidity to meet any demand that might arise. In the United States, the determination of statutory reserve requirements for banks is made by the Federal Reserve Bank; the National Credit Union Association (NCUA) makes the determination for nationally chartered credit unions. In general, the statutory reserve requirement for banks and credit unions in the United States is 10% of deposits; that is, if a bank has $100,000,000 US Dollars (USD) in deposits from customers, it can lend out up $90,000,000 USD and must keep $10,000,000 USD either in cash in its own vault or on deposit with the Federal Reserve Bank or another member bank.
Not only does the reserve requirement address liquidity issues and enhance the perception of stability for a nation's banking industry, it can also have a moderating effect on a nation's economy. If the reserve requirement is raised, the amount of money available for lending is automatically reduced, effectively slowing down economic activity. Likewise, a reduction in the reserve requirement can potentially increase the amount of money available for lending. While reserve requirements remain fairly stable in most countries, some nations, including the United Kingdom, Germany, Turkey and the United States, reduced their reserve requirements in the latter half of the 20th century, in some cases dramatically.
Statutory reserve calculations for insurance companies in the United States, on the other hand, are highly complex, and are based on each insurance policy issued by the company. The requirements are set by each state in which a company does business. The most commonly used formula for setting the reserve is the Commissioner's Reserve Valuation Method, a complex formula based on a number of factors including the policyholder's age and sex, the type of policy in force and the mortality table used to calculate the policy's present values. Thus, when meeting its statutory reserve requirements, an insurance company must use the values derived from a complex formula applied to every policy issued in a state, and set aside a liquid reserve for the sum of the reserves required for all policies. It must do this for every state in which it does business, and regularly certify to each state that the reserves it's maintaining satisfy the statutory requirement.
