Wasting Asset

Reserve Ratio (Cash Reserve Ratio): Definition, Calculation, and Impact

What is the reserve ratio?

The reserve ratio (or cash reserve ratio) is the percentage of customer deposits that commercial banks are required to hold and not lend out. Central banks set this requirement to help ensure liquidity, influence the money supply, and support overall financial stability. In the U.S., the Federal Reserve historically set reserve requirements through Regulation D and the Board of Governors.

Why it matters

• It constrains how much banks can lend and therefore affects credit creation, interest rates, and economic activity.
• Raising the reserve ratio reduces the funds available for lending, which can slow inflationary pressure.
• Lowering the reserve ratio increases lending capacity, which can stimulate growth by expanding the money supply.
• Reserves can be held as cash in vaults or as deposits at the central bank; banks may borrow from the central bank to meet shortfalls.

How to calculate the required reserve

Reserve requirement = Deposits × Reserve ratio

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

The reserve ratio and the money multiplier

Under fractional-reserve banking, the reserve ratio determines the theoretical money multiplier:

Money multiplier = 1 / reserve ratio (expressed as a decimal)

Example: With a 10% reserve ratio (0.10), the multiplier is 1 / 0.10 = 10. A deposit of $500 million could, through repeated lending and redepositing, support up to about $5 billion in total money supply in this simplified model. (Real-world outcomes differ due to currency holdings, excess reserves, and other frictions.)

Reserve interest and modern practice

Central banks may pay interest on reserves held at the central bank. The U.S. Federal Reserve has paid interest on reserves since 2008 and consolidated previous rates into a single payment framework (interest on reserve balances) in 2021. Interest on reserves affects banks’ incentives to hold excess reserves versus lending.

Recent regulatory approach (summary)

• Reserve requirements have historically been tiered by institution size, with larger banks facing higher requirements on transaction accounts and smaller institutions often subject to lower or zero requirements.
• In response to financial stress and changing policy priorities, the Federal Reserve moved to eliminate reserve requirements for many depository institutions, effectively setting the required reserve ratio to 0% for most transaction accounts. This shift means banks are not required to hold a mandated percentage of deposits at Reserve Banks, though liquidity and prudential standards remain important.

Practical implications

• Even with zero formal reserve requirements, banks still manage liquidity and capital to meet depositor withdrawals and regulatory liquidity standards.
• Changes to reserve policy are one of several monetary tools (alongside interest rates and open market operations) used by central banks to influence economic conditions.

Bottom line

The reserve ratio is a fundamental lever in the central bank toolkit that influences how much deposit money banks can convert into loans. While its practical importance has evolved—with modern practices like paying interest on reserve balances and, in many jurisdictions, setting formal reserve requirements to zero—understanding the reserve ratio helps explain the mechanics of credit creation, monetary policy transmission, and banking liquidity management.