What Is Reserve Ratio?
The reserve ratio is the percentage of customer deposits that commercial banks are required to hold in reserve rather than lend out. It is a key tool of monetary policy employed by a central bank to influence the money supply, lending capacity of financial institutions, and ultimately, economic growth. This regulatory requirement falls under the broader financial category of banking regulation. The reserve ratio helps ensure that commercial banks maintain sufficient liquidity to meet normal withdrawal demands and supports the stability of the financial system.
History and Origin
The concept of banks holding reserves against deposits dates back centuries, evolving alongside the development of fractional reserve banking. In the United States, formalized reserve requirements at the national level began with the National Bank Act of 1863, which mandated that banks operating under a national charter hold a percentage of their notes and deposits in reserve. The establishment of the Federal Reserve System in 1913 aimed to provide greater stability to the American banking system, which had frequently suffered from banking panics and a lack of flexible currency5. While initially seen as a means to ensure bank liquidity and prevent runs, the Federal Reserve's role as a lender of last resort gradually shifted the primary rationale for reserve requirements towards facilitating monetary policy.
Over time, reserve requirements were adjusted by the Federal Reserve, reflecting changing economic conditions and policy objectives. However, their significance as an active monetary policy tool began to wane. On March 15, 2020, in response to the economic disruption caused by the COVID-19 pandemic, the Federal Reserve Board announced it would reduce the reserve ratio to zero percent for all depository institutions, effective March 26, 2020. This action effectively eliminated reserve requirements.
Key Takeaways
- The reserve ratio is the percentage of customer deposits that banks must hold in reserve.
- It historically served as a central bank tool for influencing the money supply and credit availability.
- Reserves can be held as vault cash or as balances at the central bank.
- In March 2020, the U.S. Federal Reserve reduced the reserve ratio to zero for all depository institutions.
- Despite the zero reserve ratio, banks still hold significant reserves, primarily for clearing transactions and maintaining liquidity.
Formula and Calculation
Historically, the reserve ratio was calculated by dividing the required reserves by the total amount of a bank's reservable liabilities, such as demand deposits:
For example, if a bank had $100 million in deposits and the reserve ratio was 10%, it would be required to hold $10 million in reserves. The remaining $90 million could then be used for lending or other investments. While the concept of a reserve ratio remains, the elimination of mandatory reserve requirements in the U.S. means this calculation no longer dictates a minimum holding for most banks.
Interpreting the Reserve Ratio
In an environment where a reserve ratio is actively set above zero, it serves as a direct lever for monetary policy. A higher reserve ratio is generally considered a contractionary measure, as it reduces the amount of funds available for banks to lend, thereby slowing the expansion of the money supply. Conversely, a lower reserve ratio is an expansionary measure, increasing the funds available for lending and potentially stimulating economic activity.
However, in jurisdictions like the U.S. where the reserve ratio is currently set at zero, its direct interpretability as a policy tool for controlling the quantity of money has changed. Banks now hold reserves primarily to facilitate payments, clear transactions, and meet their own internal liquidity management needs, rather than to satisfy a regulatory minimum.
Hypothetical Example
Consider a hypothetical country where the central bank maintains a 5% reserve ratio. A commercial bank receives a new deposit of $1,000 from a customer. Under this reserve ratio, the bank must hold $50 (5% of $1,000) in reserve. The remaining $950 becomes "excess reserves" that the bank can lend out to other customers.
If the central bank decides to lower the reserve ratio to 3%, the same bank would only need to hold $30 in reserve from that $1,000 deposit. This action would free up an additional $20 for the bank to lend, potentially increasing the overall money supply in the economy as the lent money is redeposited and re-lent through the banking system.
Practical Applications
Historically, the reserve ratio was one of the primary tools central banks used to implement monetary policy. By adjusting the reserve ratio, authorities could directly influence the quantity of money banks had available for lending and credit creation, thereby affecting interest rates, inflation, and economic activity.
However, many modern central banks, including the U.S. Federal Reserve, now operate in an "ample reserves" framework where other tools, such as the Federal Funds Rate and quantitative easing, have become the primary instruments for managing monetary policy. Despite this shift, reserve requirements, even if set to zero, can still have indirect implications. For instance, in some emerging markets, reserve requirements continue to be used as a macroprudential tool to manage systemic risks, enhance financial stability, or contain excessive credit growth4.
Limitations and Criticisms
The effectiveness of the reserve ratio as a precision tool for monetary policy has faced several criticisms over time. One significant critique is that changes to the reserve ratio can be a blunt instrument, causing disruptive and immediate effects across the banking system. Banks often maintain "excess reserves" above the required minimum, which can dilute the impact of reserve ratio changes on their actual lending capacity.
Furthermore, critics argue that mandatory reserve requirements essentially act as a tax on commercial banks since these funds, especially if unremunerated, cannot be lent out to earn interest rates. This can put banks at a competitive disadvantage relative to non-bank financial institutions not subject to such requirements. The rise of financial innovations, such as sweep accounts, also reduced the binding nature of reserve requirements by allowing banks to reclassify customer funds overnight to avoid reserve obligations3. This further diminished their role in controlling the money supply. These factors contributed to the Federal Reserve's decision to set the reserve ratio to zero, recognizing that it no longer served its intended monetary policy purpose in a modern financial system2.
Reserve Ratio vs. Required Reserves
While often used interchangeably, "reserve ratio" and "required reserves" refer to slightly different concepts. The reserve ratio is the percentage set by the central bank that dictates how much of a bank's deposits must be held in reserve. Required reserves refer to the actual dollar amount that a bank must hold based on that ratio.
For example, if the reserve ratio is 10% and a bank has $500 million in demand deposits, the bank's required reserves would be $50 million. The reserve ratio is the rule or rate, while required reserves are the outcome of applying that rule to a bank's liabilities.
FAQs
What is the current reserve ratio in the U.S.?
As of March 26, 2020, the U.S. Federal Reserve reduced the reserve ratio for all depository institutions to zero percent. This means there are currently no mandated reserve requirements for banks in the United States.
Why did the Federal Reserve eliminate the reserve ratio?
The Federal Reserve eliminated the reserve ratio because it was no longer considered a necessary tool for implementing monetary policy. The Fed shifted to an "ample reserves" framework, where managing interest rates through other means, such as the Federal Funds Rate and the interest it pays on excess reserves, became more effective. The reserve ratio had become largely irrelevant for controlling the money supply due to financial innovations and banks holding large amounts of excess reserves.1
Does a zero reserve ratio mean banks can lend out all their deposits?
In theory, a zero reserve ratio would allow banks to lend out all their deposits. However, in practice, banks still hold significant reserves voluntarily. These reserves are held for operational reasons, such as clearing transactions, settling payments, and managing daily liquidity needs. Banks are also subject to other regulatory requirements, such as capital adequacy rules, that indirectly limit their lending.