Reserve ratio

The reserve ratio is a percentage of a bank’s total deposits that must be kept in reserve as mandated by a central bank or regulator. It is a tool used by central banks to manipulate the supply of available money in the banking system and indirectly influence economic activity. The reserve ratio is designed to ensure that banks have enough liquid assets to cover potential losses and withdrawals, and to maintain confidence in the banking system. It is closely related to the fractional reserve banking system, which requires banks to hold a fraction of their deposits in reserve and lend out the rest. By changing the reserve ratio, central banks can reduce or increase the money supply and manage the risk within the banking system.

Example of reserve ratio

• The Federal Reserve in the United States requires banks to hold a reserve ratio of 10%. This means that for every $100 of deposits, the bank must keep $10 in reserve and can lend out the remaining $90.
• The Bank of Canada requires a minimum reserve ratio of 3%. This means that for every $100 of deposits, the bank must keep $3 in reserve and can lend out the remaining $97.
• The European Central Bank requires a minimum reserve ratio of 1%. This means that for every $100 of deposits, the bank must keep $1 in reserve and can lend out the remaining $99.
• In India, the central bank requires a minimum reserve ratio of 4%. This means that for every $100 of deposits, the bank must keep $4 in reserve and can lend out the remaining $96.

When to use reserve ratio

The reserve ratio is a powerful tool that is used by central banks to regulate the money supply and manage risk in the banking system. It can be used in the following ways:

• To control the supply of money in the economy - by increasing or decreasing the reserve ratio, the central bank can influence the money supply and influence economic activity.
• To manage the risk of banks - by increasing the reserve ratio, the central bank can reduce the risk of banks by ensuring that they have enough liquid assets to cover potential losses and withdrawals.
• To encourage banks to lend - by decreasing the reserve ratio, central banks can encourage banks to lend more money to the public, which can help stimulate economic activity.
• To discourage banks from over-lending - by increasing the reserve ratio, central banks can discourage banks from over-lending and taking on too much risk.
• To maintain confidence in the banking system - the reserve ratio is an important tool for central banks to maintain confidence in the banking system by ensuring that banks have enough liquidity to cover potential losses.

Types of reserve ratio

The reserve ratio is an important tool used by central banks to regulate the money supply and manage the risk within the banking system. There are several different types of reserve ratios, each with its own purpose and implications for the banking system:

• The required reserve ratio is the percentage of deposits that banks must keep in reserve. It is set by the central bank and is typically 8-10%, depending on the country.
• The excess reserve ratio is the amount of deposits that banks can keep in reserve above the required reserve ratio. It is used to provide extra liquidity and is determined by the central bank.
• The legal reserve ratio is the percentage of deposits that banks must keep in reserve in order to comply with the law. This ratio is usually set by the government or central bank and is designed to ensure that banks have sufficient liquid assets to cover potential losses and withdrawals.
• The voluntary reserve ratio is the amount of deposits that banks choose to keep in reserve, usually in exchange for a higher interest rate. This ratio is determined by individual banks and is designed to ensure that they have enough liquidity to meet any potential demands.

Advantages of reserve ratio

The reserve ratio is a powerful tool for central banks to influence the money supply and manage risk within the banking system. The following are some of the advantages of the reserve ratio:

• It helps to maintain liquidity and stability within the banking system as banks are required to keep a portion of deposits in reserve, which can be used to cover withdrawals and potential losses.
• It can be used to reduce the risk of bank runs and other financial crises, as banks are required to keep a certain proportion of deposits on hand which can be used to meet customer demands.
• It can be used to control the money supply in the economy, as central banks can increase or decrease the required reserve ratio and thus influence the amount of money available to be loaned out.
• It provides a safety cushion for banks, as the reserve ratio is designed to ensure that banks have enough liquid assets to cover potential losses.

Limitations of reserve ratio

The reserve ratio is an important tool used by central banks to control the money supply and manage risk within the banking system. However, it also has some limitations. These include:

• It does not take into account other factors that may affect the banking system such as the availability of credit or changes in interest rates.
• It does not account for the size of a bank’s customer base and the likelihood of customers withdrawing their funds.
• It does not consider the creditworthiness of a bank’s customers and the likelihood of default.
• It does not reflect the economic conditions in a particular country or region.
• It does not address systemic risks that may arise from interconnections between banks.

Reserve ratio — recommended articles

Bank reserve requirements — Fixed exchange rate — Buffer stock — Capital buffer — Monetary base — Floating exchange rate system — Bridge Bank — International liquidity — Inflationary gap

References

• Afanasyeva, O., & Korovin, D. (2020). The impact of reserve requirements of central banks on macroeconomic indicators. Entrepreneurship and sustainability issues, 8(1), 413.