What Is the Reserve Ratio?
The reserve ratio is the portion of reservable liabilities that commercial banks must hold onto, rather than lend out or invest. This is a requirement determined by the country's central bank, which in the United States is the Federal Reserve. It is also known as the cash reserve ratio.
The minimum amount of reserves that a bank must hold on to is referred to as the reserve requirement, and is sometimes used synonymously with the reserve ratio. The reserve ratio is specified by the Federal Reserve Board’s Regulation D. Regulation D created a set of uniform reserve requirements for all depository institutions with transaction accounts, and requires banks to provide regular reports to the Federal Reserve.
- The reserve ratio, set by the central bank, is the percentage of a commercial bank's deposits that it must keep in cash as a reserve in case of mass customer withdrawals
- In the U.S., the Fed uses the reserve ratio as an important monetary policy tool to increase or decrease the economy's money supply
- The Fed lowers the reserve ratio to give banks more money to lend and boost the economy and increases the reserve ratio when it needs to reduce the money supply and control inflation
The Formula for the Reserve Ratio
Reserve Requirement=Deposits×Reserve Ratio
As a simplistic example, assume the Federal Reserve determined the reserve ratio to be 11%. This means if a bank has deposits of $1 billion, it is required to have $110 million on reserve ($1 billion x .11 = $110 million).
During the pandemic of 2020, the Federal Reserve reduced the reserve requirement to 0%.
What Does the Reserve Ratio Tell You?
The Federal Reserve uses the reserve ratio as one of its key monetary policy tools. The Fed may choose to lower the reserve ratio to increase the money supply in the economy. A lower reserve ratio requirement gives banks more money to lend, at lower interest rates, which makes borrowing more attractive to customers.
Conversely, the Fed increases the reserve ratio requirement to reduce the amount of funds banks have to lend. The Fed uses this mechanism to reduce the supply of money in the economy and control inflation by slowing the economy down.
The Fed also sets reserve ratios to ensure that banks have money on hand to prevent them from running out of cash in the event of panicked depositors wanting to make mass withdrawals. If a bank doesn't have the funds to meet its reserve, it can borrow funds from the Fed to satisfy the requirement.
Banks must hold reserves either as cash in their vaults or as deposits with a Federal Reserve Bank. On Oct. 1, 2008, the Federal Reserve began paying interest to banks on these reserves. This rate is referred to as the interest rate on required reserves (IORR). There is also an interest rate on excess reserves (IOER), which is paid on any funds a bank deposits with the Federal Reserve in excess of their reserve requirement.
Reserve Ratio Guidelines
The Board of Governors of the Federal Reserve has the sole authority over changes in reserve requirements within limits specified by law. As of March 26, 2020, the reserve requirement was set at 0%. That's when the board eliminated the reserve requirement due to the global COVID-19 pandemic. This means that banks aren't required to keep deposits at their Reserve Bank. Instead, they can use the funds to lend to their customers.
The last time the Fed updated its reserve requirements for different depository institutions before the pandemic was in January 2019. Banks with more than $124.2 million in net transaction accounts were required to maintain a reserve of 10% of net transaction accounts. Banks with more than $16.3 million to $124.2 million needed to reserve 3% of net transaction accounts. Banks with net transaction accounts of up to $16.3 million or less were not required to have a reserve requirement. The majority of banks in the United States fell into the first category. The Fed set a 0% requirement for nonpersonal time deposits and Eurocurrency liabilities.
Reserve Ratio and the Money Multiplier
In fractional reserve banking, the reserve ratio is key to understanding how much credit money banks can make by lending out deposits. For example, if a bank has $500 million in deposits, it must hold $50 million, or 10%, in reserve. It may then lend out the remaining 90%, or $450 million, which will make its way back to the banking system as new deposits. Banks may then lend out 90% of that amount, or $405 million while retaining $45 million in reserves. That $405 million will be deposited again, and so on. Ultimately, that $500 million in deposits can turn into $5 billion in loans, where the 10% reserve requirement defines the so-called money multiplier as: