We study the effectiveness of targeted reserve requirements (RR) as a policy tool for macroeconomic stabilization. Targeted RR adjustments were implemented in China during both the 2008-09 global financial crisis and the recent COVID-19 pandemic. We develop a model in which firms with idiosyncratic productivity can borrow from two types of banks—local and national—to finance working capital. National banks provide better liquidity services, while local banks have superior monitoring technologies. Switching lenders incurs a fixed cost, such that firms switch lenders only under sufficiently large shocks. Reducing RR on local banks boosts leverage and aggregate output, whereas reducing RR on national banks has an ambiguous output effect. Following a large recessionary shock, a targeted RR policy reducing relative local bank RR can stabilize macroeconomic fluctuations. However, the policy also boosts local bank leverage, raising default risks and liquidation losses. Our model’s mechanism is supported by bank-level empirical evidence.