The reserve ratio – also known as bank reserve ratio, bank reserve requirement, or cash reserve ratio – is the percentage of deposits a financial institution must hold in reserve as cash. The central bank is the institution that determines the required amount of reserve ratio. A bank’s reserve usually consists of money it has and is held in its vault. Banks also have cash kept in their account at the central bank.
Breaking Down the Reserve Ratio
Generally, the reserve ratio is used in monetary policy planning in order to regulate the amount of cash banks can convert to loans. In addition, central monetary authorities use the ratio to protect banks from a sudden decline in liquidity, which can result in a financial crisis.
Although some countries like Australia and the U.K have no reserve ratios, others, such as Lebanon and Brazil, have a reserve ratio of 30% and 20%, respectively. The figures are important because they ensure that each country is able to regulate and protect its economy.
Impact of the Reserve Ratio on Bonds and Stocks
A higher interest rate hurts bond owners, as interest rates have an inverse relationship with the value of bonds. The stock market also tends to behave negatively when interest rates surge since it’s more expensive for companies to acquire the desired level of financing. Consequently, raising the reserve requirement hurts bonds and stocks. A higher ratio appears when the economy is experiencing inflation, while a lower ratio is experienced during a deflation.
In particular, banks have a hard time when the central bank adjusts the reserve ratio upward because there is a limit to the amount of money banks can lend and, therefore, to the amount of interest they can earn. The reverse is true when the central bank lowers the reserve ratio. Banks have more money to lend, and more interest is generated.
In certain countries, some amount of money is paid to banks as interest on their reserves. The practice is usually beneficial to banks, but it depends on prevailing rates. For example, the U.S. Federal Reserve pays about 0.5% on reserve ratios as compensation to banks for income lost when the reserve requirement is increased.
International investors need to keep a close eye on reserve ratios, especially in markets that rely on reserve requirements to manage monetary policies. In many cases, stockholders are able to tell when variations in reserve ratios will take place by scrutinizing macroeconomic patterns.
A country whose inflation is rising will typically experience a rise in its reserve ratio. An investor can hedge such risks by investing in multiple regions and countries. An investor can also shift his investments into areas that are not influenced by changes in the ratio.
Impact on Monetary Policy
Most central banks, like the Bank of England, the U.S. Federal Reserve System, and the European Central Bank, tend not to change reserve rates often because it can cause liquidity problems. Instead, they utilize open market operations such as quantitative easing.
For example, the reserve ratio in the U.S. is limited to 10% for deposits and 0% for time deposits spanning many years. The figures are discussed and set by a board of governors. Like time deposits, savings accounts are not affected by reserve requirements.
Increasing the percentage of deposits that banks must keep in the form of vault cash causes a decrease in the amount of lending that they are able to do. While the effectiveness of reserve requirements as a policy tool is highly debatable, there’s little doubt that it influences the money market. Their use is becoming less relevant in countries such as the U.S., where regulators preferring quantitative easing instead.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: