Reserve Ratio

Reserve Ratio — Definition, Calculation, and Impact

The reserve ratio (or cash reserve ratio) is the percentage of a bank’s deposits that must be held as reserves rather than lent or invested. Central banks set reserve requirements to ensure liquidity, influence the money supply, and help stabilize the economy.

How the Reserve Ratio Is Calculated

Formula:
Reserve requirement = Deposits × Reserve ratio

Example:
– If the reserve ratio is 11% and a bank has $1 billion in deposits, required reserves = 0.11 × $1,000,000,000 = $110,000,000.

Why It Matters

• Monetary policy tool: Changing the reserve ratio alters how much banks can lend. Lowering the ratio expands the money supply and can stimulate lending and economic activity. Raising the ratio contracts lending and can help control inflation.
• Liquidity and safety: Reserve requirements ensure banks hold cash or central bank deposits to meet withdrawals and reduce the risk of runs.
• Regulatory mechanism: If a bank cannot meet its reserve requirement, it may borrow from the central bank or other sources to comply.

How Reserves Are Held and Compensated

Banks hold reserves as cash in vaults or as deposits at the central bank. Many central banks pay interest on reserves held at the central bank (a unified interest-on-reserve balances policy has replaced earlier separate rates in some jurisdictions), which affects banks’ incentives to hold reserves versus lend.

Reserve Ratio and the Money Multiplier

In a fractional reserve banking system, the reserve ratio determines the theoretical money multiplier:
Money multiplier = 1 / reserve ratio (decimal)

Example with a 10% reserve ratio:
– Initial deposits: $500 million → required reserves $50 million, available to lend $450 million.
– That $450 million gets redeposited and a portion lent again, repeating the cycle.
– The maximum potential expansion of the money supply is roughly 1 / 0.10 = 10 times the initial reserves.

Recent Practice and Trends

Some central banks have adjusted reserve requirements in response to economic conditions. For example, reserve requirements were temporarily reduced in 2020 in response to the global pandemic, effectively allowing banks greater lending capacity. Rules about which liabilities are reservable (transaction accounts, certain time deposits, and similar items) vary by jurisdiction.

Who Sets the Reserve Ratio

Reserve requirements are set by a country’s central bank or monetary authority within limits established by law. These authorities can change ratios to pursue macroeconomic objectives like controlling inflation, supporting growth, or maintaining financial stability.

Bottom Line

The reserve ratio is a fundamental regulatory tool in banking and monetary policy. By dictating the portion of deposits banks must hold back from lending, it directly influences liquidity, credit creation, and broader economic conditions. Understanding how reserve requirements work helps explain shifts in lending capacity and central bank policymaking.