Reserve requirements as a financial stability instrument.

We quantify the economic trade-offs of using reserve requirements (RR) with a financial stability objective. We estimate the costs of a tightening in RR by calculating the fall of bank credit and industrial production growth in a panel VAR. Then, we estimate the benefits by calculating the drop in frequency and incidence of financial distress episodes in an early warning system model. We find that RR are an effective financial stability tool. The economic gains from a lower probability of financial distress more than compensate the initial reduction in economic activity. Additionally, we find that the effects of RR, both in terms of costs and benefits, are greater in emerging market economies compared to advanced economies. Finally, we show that single RR and RR by maturity have a greater positive effect, whereas RR by currency could be responding to other objectives such as financial dedollarization.