We build a two-sector DSGE model of the Chinese economy to study the role of reserve requirement policy for capital reallocation and business cycle stabilization. In the model, state-owned enterprises (SOEs) have lower average productivity than private firms, but they have superior access to bank loans because of government guarantees. Private firms rely on “shadow” bank financing. Commercial banks are subject to reserve requirement regulations but shadow banks are not. Our framework implies a tradeoff for reserve requirement policy: Increasing the required reserve ratio acts as a tax on SOE activity and reallocates resources to private firms, raising aggregate productivity. This reallocation is supported by empirical evidence. However, raising reserve requirements also increases the incidence of costly SOE failures. Under our calibration, reserve requirement policy can be complementary to interest rate policy for stabilizing macro fluctuations and improving welfare.