Bank reserves are the minimum cash reserves that financial institutions must keep in their vaults at any given time. The minimum cash reserve requirements for financial institutions in each country are set by the central bank of that country.
For example, the Federal Reserve is responsible for setting the requirements for financial institutions in the United States. Similarly, the Reserve Bank of India (RBI) is the equivalent governing body for financial institutions in India.
Bank Reserve Requirements
Bank reserve requirements are set as a supervisory regulation to ensure that major financial institutions possess enough liquidity for withdrawals and obligations and for withstanding the impact of unforeseen market conditions.
Minimum cash reserves are generally set as a fixed percentage of a bank’s deposits and can be calculated using the reserve ratio. For example, if a financial institution holds $1,000,000 in deposits and the reserve ratio is set at 10%, then the minimum cash reserve the financial institution needs to maintain is $100,000 ($1,000,000 * 10%).
Reserve Requirement = Reserve Ratio * Total Deposits
In some cases, financial institutions are unable to meet their reserve requirement on their own. In such cases, they can borrow from other financial institutions with excess reserves at the overnight rate. The overnight rate, or bank rate, is the rate at which financial institutions borrow from one another. The rate is generally close to or equal to the target rate set by the central bank of the country.
Guidelines for Setting the Reserve Ratio
The central banks in each country are responsible for setting the reserve ratio. While each country follows a slightly different framework for setting the reserve ratio, the main criterion is the size/amount of deposits. Banks with larger accounts are subject to higher reserve ratio requirements.
Banks are generally grouped into pre-determined categories based on their size and overall importance to the economy. Each category is subject to a different reserve ratio and, therefore, the reserve ratio for a particular bank depends on the classification the bank falls under.
Reserve Requirements and Monetary Policy
Central banks globally use the reserve ratio as a key tool to implement monetary policy and to control the money supply and interest rates. A change in reserve ratio requirements can tell a lot about the monetary policy the central banks plan to implement in the near future.
A lower reserve ratio means that banks hold more capital available for lending. It would imply an increase in the money supply in an economy. When the money supply increases, interest rates fall. Similarly, a higher reserve ratio leads to a decrease in the money supply and an increase in interest rates.
While central banks set target rates, they cannot force banks to implement the rate. However, they can indirectly control the interest rates by modifying reserve requirements and changing the money supply in the economy. In recessionary periods, central banks can revive the economy by reducing the reserve ratio. Doing so will increase the money supply in the economy and decrease interest rates, which will boost spending and investments in the economy.
Similarly, to prevent the economy from overheating during inflationary periods, central banks can increase reserve requirements for banks. It will lead to a decrease in the money supply and an increase in interest rates, which will ultimately slow down investment in the economy.
Bank Reserves and Open Market Operations
Open market operations refer to the phenomenon of central banks buying and selling government securities in the open market. In addition to changing reserve requirements, central banks can also use open market operations to control the money supply and interest rates in the economy.
If central banks are aiming for an expansionary monetary policy, they can buy government treasuries from financial institutions on the open market. It leads to an inflow of cash for financial institutions, which allows them to increase lending. As the money supply in the economy grows, interest rates fall and consumers and businesses can obtain more credit to make purchases and investments.
Similarly, central banks can carry out a contractionary monetary policy by selling government treasuries on the open market. It pulls out money from the economy. As the money supply in the economy declines, banks charge higher interest rates on loans, making it difficult for consumers and businesses to obtain credit. Such a move slows down consumption and investment and prevents the economy from overheating.
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