What is the Reserve Ratio?
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 only institution that determines the 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
Changes in interest rates have a direct impact on the reserve rate of bonds and stocks. A higher interest rate hurts bond owners, as interest rates have a transposed relationship with the value of bonds.
The stock market also tends to behave negatively when interest rates surge since it’s more expensive for banks 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.
Part of the stock market may also be affected by changes in the reserve requirement. In particular, banks have a hard time when the central bank adjusts the reserve ratio upwards because there is a limit to the amount of money banks can lend, and the interest generated is small. 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 reserve ratios. 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 also experience a rise in its reserve ratio. Thus, an investor can hedge off such risks by investing in multiple regions and countries. In such a way, a shift in reserve ratio in a given country won’t result in a substantial effect all throughout a business empire. An investor can also shift his uncertainty 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 because it can cause liquidity problems. Changing reserve requirements causes banks not to have enough reserves to offer loans to their customers. Instead, the countries take advantage of open market operations like 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.
Reserve requirements greatly affect checking accounts, and for this reason, banks with a significant number of checking customers tend to hold reserve deposits in order to meet the 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 willing to do. Increasing the reserve ratio is often employed when the economy is suffering. The measure helps improve the state of the economy.
While the effectiveness of reserve requirements as a policy tool is highly debatable, there’s little doubt that it influences the money market in the end. Nevertheless, its 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 resources below will be useful: