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.
U.S. commercial banks are required to hold reserves against their total reservable liabilities (deposits) which cannot be lent out by the bank. Reservable liabilities include net transaction accounts, nonpersonal time deposits and Eurocurrency liabilities.
The reserve amount is referred to as the reserve requirement and is expressed as a percentage known as 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 Formula for the Reserve Ratio
Reserve Ratio=Deposits x Reserve Requirement
How to Calculate the 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).
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.
- The reserve ratio, set by the Federal Reserve, is the percentage of a commercial bank's deposits that it must keep in cash as a reserve in case of mass customer withdrawals
- 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
Reserve Ratio Guidelines
Within limits specified by law, the Board of Governors of the Federal Reserve has the sole authority over changes in reserve requirements. In January 2019, the Fed updated its reserve requirements for depository institutions of different sizes.
Banks with more than $124.2 million in net transaction accounts must maintain a reserve of 10% of net transaction accounts. Banks with more than $16.3 million to $124.2 million must reserve 3% of net transaction accounts. Banks with net transaction accounts of up to $16.3 million or less do not have a reserve requirement. The majority of banks in the United States fall into the first category. The Fed set a 0% requirement for nonpersonal time deposits and Eurocurrency liabilities.