What Is the Reserve Ratio?
The reserve ratio represents the portion of reservable liabilities that commercial banks must hold in reserve, rather than disbursing for loans or investments. This regulation is instituted by the central bank of the country—in the United States, it is managed by the Federal Reserve. The reserve ratio is also referred to as the cash reserve ratio.
The minimum amount of reserves a bank must hold is known as the reserve requirement. This term is often used interchangeably with the reserve ratio. In the United States, the Federal Reserve Board’s Regulation D stipulates these requirements, ensuring uniform reserve obligations for all depository institutions. Banks regularly report their reserve levels to the Federal Reserve.
Key Insights to Inspire Greater Understanding
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Safeguarding Financial Stability: The reserve ratio, defined by the central bank, is the percentage of a commercial bank’s deposits that it must retain as liquid cash reserves. This is crucial for averting potential crises triggered by mass customer withdrawals.
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A Vital Monetary Policy Instrument: In the U.S., the Federal Reserve deploys the reserve ratio to modulate the money supply. Lowering the reserve ratio amplifies the lending capacity of banks, replenishing the economy’s liquidity. Conversely, increasing the ratio constricts lending, helping to manage inflationary pressures.
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Boosting Economic Growth: By tweaking the reserve ratio, the Federal Reserve catalyzes economic stimuli. A reduced reserve ratio translates to more accessible loans at equitable interest rates, fueling business expansions and consumer spending.
Formula for the Reserve Ratio
To calculate the reserve requirement, the following formula applies:
Reserve Requirement = Deposits × Reserve Ratio
For instance, if the Federal Reserve mandates an 11% reserve ratio and a bank has deposits totaling $1 billion, the bank would need to hold $110 million in reserve ($1 billion × 0.11 = $110 million).
Adapting During Economic Fluctuations
During the 2020 pandemic, the Federal Reserve drastically reduced the reserve requirement to 0%, reflecting its responsive adaptation to unprecedented financial conditions.
What Insights Does the Reserve Ratio Offer?
The Federal Reserve leverages the reserve ratio as a core mechanism for monetary control. By lowering the reserve ratio, the Fed induces banks to increase their lending capacity, thereby bolstering economic activity through easier borrowing options. In scenarios necessitating tighter control, raising the reserve ratio requires banks to hold more in reserve, reducing the lendable sums and cooling economic activity to maintain inflation targets.
The ratio is also a safeguard ensuring that banks retain sufficient liquidity to satisfy withdrawal demands and manage unforeseen circumstances. Banks can also borrow from the Federal Reserve to meet their reserve shortfalls if required.
Banks maintain their reserves either as cash in their vaults or as deposits with Federal Reserve Banks. Since October 2008, these reserve deposits earn interest, currently defined by the Interest on Reserve Balances (IORB), streamlining previously separate resources (IORR and IOER) as of July 2021. The rate of IORB was 0.10% as of 2022.
Reserve Ratio Directives
The Federal Reserve Board of Governors holds exclusive power over adjusting reserve requirements within legally defined parameters. As of March 26, 2020, the reserve requirement was temporarily set to 0% in response to the global financial crisis, allowing banks to fully utilize deposits for lending propositions.
Previously, as of January 2019, banks operating with over $124.2 million in net transaction accounts had a mandated reserve of 10%. Institutions with $16.3 million to $124.2 million needed to reserve 3% of accounts, whereas those below $16.3 million had no reserve obligation. A 0% requirement persisted for nonpersonal time deposits and Eurocurrency liabilities.
The Reserve Ratio in Fractional Reserve Banking
In a fractional reserve banking system, the reserve ratio is fundamental in determining the extent of credit a bank can issue from deposits. For example, with $500 million in deposits and a 10% reserve ratio, banks hold $50 million in reserve while lending $450 million. These loaned funds eventually return to the banking infrastructure as new deposits. A perpetual lending cycle ensues, converting the initial $500 million into $5 billion in loans, exemplified by the money multiplier effect.
Related Terms: Fractional Reserve Banking, Money Multiplier, Central Bank, Reserve Requirement.
References
- Board of Governors of the Federal Reserve Board. “Reserve Requirements”.
- Board of Governors of the Federal Reserve. “Press Release: October 6, 2008”.
- Board of Governors of the Federal Reserve Board. “Federal Reserve Board issues final rule amending Regulation D with regard to interest on reserve balances”.
- EideBailly. “Federal Reserve Eliminates Reserve Requirements”.
- Board of Governors of the Federal Reserve. “Federal Reserve Board Announces Annual Indexing of Reserve Requirement Exemption Amount and of Low Reserve Tranche for 2020”.
