What Is Required Reserve Ratio?
The required reserve ratio is the fraction of customer deposits that commercial banks are mandated to hold in reserve, rather than lend out. This requirement is a tool of monetary policy used by a central bank to influence the amount of money circulating in an economy, thereby affecting credit availability and overall financial stability. The required reserve ratio impacts the capacity of banks to engage in lending and, consequently, the money supply.
History and Origin
The concept of banks holding a portion of their deposits as reserves dates back centuries to the origins of fractional reserve banking. In the United States, formalized reserve requirements were established at the national level with the passage of the National Bank Act in 1863. This act mandated that banks hold a specific percentage of their notes and deposits as reserves. Historically, the purpose of these requirements evolved from ensuring bank liquidity during panics to becoming a primary instrument of monetary policy. For decades, the Federal Reserve used adjustments to the required reserve ratio as a means to control the money supply. However, the role of reserve requirements in monetary policy shifted significantly over time. As announced on March 15, 2020, the Board of Governors of the Federal Reserve System reduced reserve requirement ratios to zero percent, effective March 26, 2020, effectively eliminating reserve requirements for all depository institutions in the United States.6
Key Takeaways
- The required reserve ratio specifies the minimum percentage of deposits that banks must hold as reserves.
- Historically, it was a key tool of monetary policy for central banks to manage the money supply.
- In the United States, the required reserve ratio was reduced to zero percent in March 2020.
- Despite its elimination in the U.S., reserve requirements remain a relevant policy tool in many other countries for managing economic conditions.
- Changes to the ratio can impact banks' lending capacity, affecting economic growth and inflation.
Formula and Calculation
Before the required reserve ratio was set to zero in the U.S., it was typically calculated as a percentage of a bank's total transaction deposits. The formula for the minimum amount of reserves a bank was required to hold was:
[
\text{Required Reserves} = \text{Required Reserve Ratio} \times \text{Total Deposits}
]
Where:
- Required Reserves: The minimum amount of funds a bank must hold in its vault cash or at the central bank.
- Required Reserve Ratio: The percentage set by the central bank.
- Total Deposits: The sum of all eligible customer deposits held by the bank.
For instance, if a bank had $100 million in total deposits and the required reserve ratio was 10%, it would be required to hold $10 million in reserves. The remaining $90 million would be considered "excess reserves" and could be used for lending or other investments.
Interpreting the Required Reserve Ratio
Historically, the required reserve ratio was a direct lever for central banks to influence the banking system's capacity to create money through lending. A higher required reserve ratio meant banks had less money available for loans, which could slow down economic activity and curb inflation. Conversely, a lower required reserve ratio freed up more funds for banks to lend, potentially stimulating economic growth. In the modern financial landscape, particularly in countries like the U.S. where the ratio is zero, central banks rely more heavily on other monetary policy tools, such as adjusting interest rates and conducting open market operations, to achieve their policy objectives.
Hypothetical Example
Consider a hypothetical country where the central bank maintains a required reserve ratio of 5%. If Commercial Bank A receives $50 million in new customer deposits, it would need to calculate its required reserves.
- Required Reserves = 5% of $50,000,000
- Required Reserves = 0.05 \times $50,000,000 = $2,500,000
This means Commercial Bank A must set aside $2.5 million and cannot lend it out. The remaining $47.5 million would be considered excess reserves, which the bank could then use for lending to individuals or businesses. This example illustrates how the required reserve ratio directly limits the amount of money banks can create through the loan process.
Practical Applications
While the Federal Reserve in the U.S. has set its required reserve ratio to zero, reserve requirements remain a significant monetary policy tool for many central banks around the world, particularly in emerging markets. The International Monetary Fund (IMF) notes that reserve requirements are an instrument used to influence the demand for reserves at the central bank, aiding in mandates of price and financial stability.5
In these economies, the required reserve ratio can serve several purposes:
- Controlling Money Supply: By adjusting the ratio, central banks can directly influence the amount of money available for lending in the financial system.
- Managing Liquidity: It helps in regulating the liquidity within the banking sector, ensuring banks maintain adequate funds to meet withdrawals and obligations.
- Macroprudential Tool: In some cases, higher reserve requirements are used to curb excessive credit growth and prevent asset bubbles, thereby supporting overall financial stability.4
Limitations and Criticisms
Despite its historical significance, the required reserve ratio has faced criticisms and has seen its role diminish in many developed economies. One major critique is that it acts as a tax on commercial banks, as reserves typically earn little or no interest, putting depository institutions at a competitive disadvantage compared to other financial entities.3 This "reserve tax" can disincentivize banks from attracting deposits.
Another limitation is its bluntness as a policy instrument. Adjusting the required reserve ratio can have a significant and sometimes unpredictable impact across the entire banking sector, making it less precise than other tools like interest rates or open market operations. Furthermore, financial innovations, such as sweep accounts, have historically allowed banks to reduce their required reserve balances even when the ratio was non-zero, diminishing its effectiveness.2 The decision by the Federal Reserve to reduce the ratio to zero reflects a broader trend among many central banks to de-emphasize this tool in favor of more flexible and targeted approaches to monetary policy.
Required Reserve Ratio vs. Discount Rate
The required reserve ratio and the discount rate are both tools historically employed by a central bank as part of its monetary policy, but they operate differently and target distinct aspects of the banking system:
| Feature | Required Reserve Ratio | Discount Rate |
|---|---|---|
| Definition | The percentage of customer deposits that commercial banks must hold in reserve. | The interest rates at which commercial banks can borrow money directly from the central bank. |
| Direct Impact | Affects the amount of funds banks must hold and, consequently, the amount available for lending. | Influences the cost of short-term borrowing for banks, which can affect the rates they charge customers. |
| Mechanism | A direct regulation on bank balance sheets, mandating a minimum level of reserves. | An administered rate that signals the central bank's stance and affects banks' incentive to borrow reserves. |
| Application | Limits the money creation process through fractional reserve banking. | Provides liquidity to banks and influences short-term market rates. |
While the required reserve ratio directly dictates how much money banks cannot lend, the discount rate influences the cost for banks to acquire additional funds, thereby indirectly affecting their lending behavior.
FAQs
What is the current required reserve ratio in the U.S.?
As of March 2020, the Federal Reserve reduced the required reserve ratio for all U.S. depository institutions to zero percent. This means banks are no longer legally required to hold a specific percentage of their deposits as reserves.1
Why did the Federal Reserve eliminate the required reserve ratio?
The Federal Reserve eliminated the required reserve ratio because it was no longer considered a primary tool for implementing monetary policy. The central bank now primarily influences the money supply and interest rates through other mechanisms, such as adjusting the interest paid on excess reserves and conducting open market operations.
Do other countries still use a required reserve ratio?
Yes, many countries, especially emerging market economies, continue to use the required reserve ratio as an active tool of monetary policy to manage liquidity, inflation, and financial stability. The specific ratios and their application vary widely by country.