What is the Reserve Ratio?
The reserve ratio is a fundamental concept in banking that represents the fraction of total customer deposits that a bank keeps as reserves. These reserves are held either as cash in the bank's vault or as deposits at the central bank (Federal Reserve in the United States).
Banks don't keep all deposited money on hand. Instead, they lend out a significant portion to borrowers, earning interest and fueling economic activity. The reserve ratio determines how much must be kept in reserve versus how much can be lent out.
For example, if a bank has $100 million in deposits and keeps $10 million in reserves, its reserve ratio is 10% (0.10). This means for every dollar deposited, the bank holds 10 cents in reserve and can potentially lend out 90 cents.
Fractional Reserve Banking Explained
Fractional reserve banking is the banking system used by virtually all modern banks worldwide. Under this system, banks are required to hold only a fraction of their deposits as reserves, allowing them to lend out the remainder.
This system serves several purposes:
- Economic Growth: By lending out deposits, banks provide capital for businesses and individuals, fueling economic activity
- Money Creation: Through the lending process, banks effectively create new money in the economy
- Interest Income: Banks earn profit by charging interest on loans, which is higher than what they pay depositors
- Liquidity Management: Banks must balance profitability from loans with maintaining enough reserves to meet withdrawal demands
How to Calculate Reserve Ratio
Calculating the reserve ratio is straightforward and requires only two pieces of information:
Let's break down the components:
- Bank Reserves: The sum of cash held in the bank's vault plus deposits at the central bank
- Total Deposits: All demand deposits (checking accounts) and other deposits that customers can withdraw
Step-by-Step Calculation
- Determine the total deposits held by the bank
- Find the total reserves (vault cash + central bank deposits)
- Divide reserves by deposits
- Multiply by 100 to get the percentage
The Money Multiplier Effect
One of the most fascinating aspects of fractional reserve banking is the money multiplier effect. When a bank makes a loan, the borrowed money typically gets deposited in another bank, which can then lend out a portion of that deposit, and so on.
For example, with a 10% reserve ratio:
- Money Multiplier = 1 ÷ 0.10 = 10
- An initial deposit of $1,000 could theoretically create up to $10,000 in the money supply
| Reserve Ratio | Money Multiplier | $1,000 Deposit Creates |
|---|---|---|
| 5% | 20x | $20,000 |
| 10% | 10x | $10,000 |
| 15% | 6.67x | $6,670 |
| 20% | 5x | $5,000 |
| 25% | 4x | $4,000 |
Required vs. Excess Reserves
Banks typically hold two types of reserves:
Required Reserves
These are the minimum reserves that banks must hold as mandated by the central bank. The required reserve ratio determines this minimum.
Excess Reserves
Any reserves held above the required minimum are called excess reserves. Banks may hold excess reserves for several reasons:
- To meet unexpected withdrawal demands
- To have funds available for profitable lending opportunities
- To earn interest on reserves (the Fed pays interest on excess reserves)
- During uncertain economic times for safety
Reserve Requirements and Monetary Policy
Central banks use reserve requirements as one of several tools to implement monetary policy. By adjusting the required reserve ratio, they can influence:
- Money Supply: Higher reserve requirements reduce the money multiplier, contracting the money supply. Lower requirements expand it.
- Interest Rates: Changes in reserve requirements affect the supply of loanable funds, influencing interest rates.
- Credit Availability: Banks with more excess reserves can make more loans, increasing credit availability.
- Economic Activity: Through these mechanisms, reserve requirements can stimulate or slow economic activity.
Current Reserve Requirements
In a historic move, the Federal Reserve reduced reserve requirements to zero on March 26, 2020, in response to the COVID-19 pandemic. This was part of a broader effort to support lending and economic activity during the crisis.
Before this change, reserve requirements were:
| Net Transaction Accounts | Reserve Requirement |
|---|---|
| $0 - $16.9 million | 0% |
| $16.9 million - $127.5 million | 3% |
| Over $127.5 million | 10% |
Calculation Examples
Example 1: Basic Reserve Ratio Calculation
A community bank has the following:
- Total customer deposits: $50,000,000
- Vault cash: $2,000,000
- Deposits at Federal Reserve: $3,000,000
Solution:
Total Reserves = $2,000,000 + $3,000,000 = $5,000,000
Reserve Ratio = $5,000,000 ÷ $50,000,000 = 0.10 = 10%
Example 2: Excess Reserves Calculation
Using the same bank from Example 1, with a required reserve ratio of 8%:
Required Reserves = $50,000,000 × 0.08 = $4,000,000
Excess Reserves = $5,000,000 - $4,000,000 = $1,000,000
The bank has $1 million in excess reserves that it could potentially lend out.
Example 3: Money Multiplier
With a 10% reserve ratio:
Money Multiplier = 1 ÷ 0.10 = 10
If the bank receives a new deposit of $100,000, this could theoretically create up to $1,000,000 in new money supply through the banking system.
Frequently Asked Questions
What happens if a bank falls below the required reserve ratio?
Banks that fall below required reserves must take corrective action, such as borrowing from other banks in the federal funds market, borrowing from the Federal Reserve's discount window, or calling in loans. Persistent violations can result in penalties and increased regulatory scrutiny.
Why do banks hold excess reserves?
Banks hold excess reserves for precautionary reasons, to meet unexpected withdrawals, take advantage of lending opportunities, and because the Federal Reserve pays interest on excess reserves (IOER), making them a safe, interest-bearing asset.
How does the reserve ratio affect interest rates?
A higher reserve ratio means banks have less money to lend, reducing the supply of loanable funds and potentially raising interest rates. Conversely, a lower reserve ratio increases lending capacity and can lower rates.
What is the difference between reserve ratio and capital ratio?
The reserve ratio relates to deposits and reserves, measuring short-term liquidity. The capital ratio (or capital adequacy ratio) compares a bank's capital to its risk-weighted assets, measuring its ability to absorb losses and long-term solvency.
Can the money multiplier be negative?
No, the money multiplier cannot be negative as it's calculated as 1 divided by a positive reserve ratio. However, if banks hold significant excess reserves and don't lend, the actual money creation can be much less than the theoretical maximum.
How do reserve requirements differ internationally?
Reserve requirements vary significantly across countries. Some countries like the UK, Canada, and Australia have no formal reserve requirements, relying on capital adequacy rules instead. Others, like China, maintain relatively high reserve ratios as a monetary policy tool.