What Is Designated Reserve Ratio?
A designated reserve ratio refers to the percentage of a commercial bank's deposits that it is required to hold in reserve, rather than lend out. This amount is typically held either as vault cash or as balances at the country's central bank. The designated reserve ratio is a key tool in monetary policy, falling under the broader category of banking regulation. It influences the amount of money available for lending within the financial system and, consequently, impacts the overall money supply.
History and Origin
The concept of banks holding a portion of their customer deposits in reserve dates back centuries, evolving from a prudential measure to ensure liquidity into a formal regulatory tool. In the United States, state-level reserve requirements first appeared shortly after the Panic of 1837, intended to ensure banks could meet their liability obligations. However, these requirements alone often proved insufficient to prevent banking panics19. The first national reserve requirements were established in the U.S. with the National Bank Act of 1863, which mandated that banks hold a specific percentage of their notes and deposits as reserves18.
With the establishment of the Federal Reserve System in 1913, the role of reserve requirements shifted. While still seen as a component of bank safety, their primary function transitioned to serving as a tool for the Federal Reserve to implement its monetary policy. Over time, the rationale for these requirements has continued to evolve alongside the financial system17. For instance, the Federal Reserve Board reduced reserve requirement ratios for all depository institutions to zero percent, effective March 26, 202016. Similarly, in the Eurosystem, the European Central Bank (ECB) has maintained a uniform minimum reserve ratio of 1% since January 2012, applied to certain liabilities on banks' balance sheets, primarily customer deposits and debt securities15,14.
Key Takeaways
- The designated reserve ratio is the percentage of deposits banks must hold in reserve.
- It is a fundamental tool of monetary policy, influencing the money supply and bank lending capacity.
- Central banks, such as the Federal Reserve and the European Central Bank, determine and enforce these ratios.
- Historically, reserve requirements aimed to ensure bank liquidity and later became a tool for monetary control.
- While some central banks maintain a positive designated reserve ratio, others have reduced it to zero.
Formula and Calculation
The designated reserve ratio is not typically calculated by banks; rather, it is a percentage set by the central bank. However, a bank's required reserves are calculated based on this ratio and its qualifying liabilities. The formula for calculating the required reserves is:
Where:
- Required Reserves represents the minimum amount of funds a bank must hold.
- Designated Reserve Ratio is the percentage set by the central bank.
- Reservable Liabilities are the specific types of deposits and other liabilities that the central bank mandates reserves be held against. These often include net transaction accounts, although definitions can vary by jurisdiction13.
For example, the European Central Bank calculates minimum reserve requirements as 1% of specific liabilities on banks' balance sheets, mainly customer deposits and debt securities with maturities up to two years12.
Interpreting the Designated Reserve Ratio
The interpretation of the designated reserve ratio depends on its level and the broader economic context. A higher designated reserve ratio means commercial banks must hold more funds and have less to lend, which tends to reduce the money supply and can lead to higher interest rates. Conversely, a lower ratio frees up more funds for lending, potentially increasing the money supply and stimulating economic growth.
Central banks use the designated reserve ratio as one lever to implement monetary policy. Changes to this ratio are generally made with careful consideration because abrupt adjustments can significantly affect bank liquidity and the stability of the financial system.
Hypothetical Example
Consider a hypothetical country where the central bank sets a designated reserve ratio of 5%. If a commercial bank, "DiversiBank," has $100 million in reservable liabilities, its required reserves would be calculated as follows:
DiversiBank must hold at least $5 million in its reserves, either as vault cash or as deposits at the central bank. The remaining $95 million ($100 million - $5 million) is available for lending to customers, subject to other regulatory considerations like capital requirements. If the central bank were to reduce the designated reserve ratio to 3%, DiversiBank's required reserves would drop to $3 million, freeing up an additional $2 million for lending.
Practical Applications
The designated reserve ratio plays a crucial role in banking and monetary policy:
- Monetary Control: Central banks use it as a tool to influence the overall money supply and credit conditions in an economy. Raising the ratio can curb inflation by limiting lending, while lowering it can stimulate economic activity.
- Banking Regulation: It helps ensure that commercial banks maintain a certain level of liquidity to meet unexpected withdrawals and maintain financial stability.
- Historical Context: In the U.S., prior to March 2020, reserve requirements were a component of the Federal Reserve's implementation framework, influencing banks' demand for reserves. Effective March 26, 2020, the Federal Reserve reduced reserve requirement ratios to zero percent11. However, the Board of Governors continues to make annual adjustments to the reserve requirement exemption amount and the low reserve tranche, as mandated by statute, even with the zero percent ratio10. This demonstrates how regulations around reserve requirements can evolve.
- International Variations: Different central banks maintain varying designated reserve ratios. For example, the European Central Bank specifies minimum reserve requirements for credit institutions in the euro area, requiring them to hold deposits with their national central bank9.
Limitations and Criticisms
While historically significant, the effectiveness and relevance of the designated reserve ratio as a monetary policy tool have been debated. Critics point out several limitations:
- Less Direct Control: In modern financial systems, particularly those with ample bank reserves, central banks often rely more heavily on open market operations and administered interest rates (like the interest paid on reserves) to manage the money supply. For instance, the Federal Reserve's decision to set all reserve requirement ratios to zero in March 2020 reflects a shift towards other tools8.
- Liquidity Hoarding: A high designated reserve ratio can compel banks to hold excess reserves, potentially hindering lending and economic activity, especially during times of uncertainty.
- Administrative Burden: For banks, calculating and reporting reserve requirements, even if the ratio is zero, still involves some administrative effort. The annual indexing of the reserve requirement exemption amount and low reserve tranche by the Federal Reserve is an example of ongoing regulatory adjustments7.
- Not a Guarantee of Liquidity: Historically, even with reserve requirements in place, banking panics and liquidity crises occurred, demonstrating that mandated reserves alone do not fully prevent such events6. This led to the creation of central banks as lenders of last resort. As noted in a Federal Reserve Bank of Richmond article, reserve requirements have not always served their intended functions well5.
Designated Reserve Ratio vs. Reserve Requirement
The terms "designated reserve ratio" and "reserve requirement" are closely related and often used interchangeably, but they refer to slightly different aspects of the same regulatory framework within monetary policy.
The designated reserve ratio is the specific percentage set by a central bank. It is the rate applied to a bank's liabilities to determine how much it must hold in reserve. For example, a central bank might set a designated reserve ratio of 10%.
The reserve requirement refers to the absolute amount of funds that a bank must hold, calculated by applying the designated reserve ratio to its eligible deposits and other liabilities. It is the numerical obligation resulting from the application of the ratio.
In essence, the designated reserve ratio is the rate, while the reserve requirement is the resultant amount that banks must hold. The European Central Bank defines minimum reserve requirements as the funds banks are required to hold in their accounts at their national central bank, determined by applying a uniform positive minimum reserve ratio4.
FAQs
Why do central banks set a designated reserve ratio?
Central banks set a designated reserve ratio primarily to influence the amount of money banks can lend, thereby controlling the overall money supply and managing inflation or stimulating economic growth. Historically, it also served as a prudential measure to ensure bank liquidity.
What happens if a bank does not meet its designated reserve ratio?
If a bank fails to meet its designated reserve ratio, it can face penalties from the central bank, which may include fines. While often linked to technical errors rather than a bank's lack of funds, such breaches are taken seriously by regulators3.
Do all countries have a positive designated reserve ratio?
No, not all countries maintain a positive designated reserve ratio. For example, the Federal Reserve in the United States reduced its reserve requirement ratios to zero percent effective March 26, 20202. Other central banks, like the European Central Bank, continue to apply a positive ratio1. The decision to maintain or eliminate a reserve ratio depends on the central bank's monetary policy framework and the specific conditions of its financial system.