The percentage of cash a commercial bank legally requires to hold proportional to the amount of money deposited.
The reserve ratio (RR) is the percentage of cash a commercial bank legally requires to hold proportional to the amount of money deposited.
The exact ratio is generally created by a nation's central bank and is commonly expressed as a percentage.
While banks can hold as much cash as they want above the reserve ratio, they may not go below, making the balance a minimum requirement rather than a requirement in both directions.
For example, let's say that the reserve ratio required in Bankland is 0.05 or 5%. The total value of deposits in bank accounts in the Bank of Bankland is $1 million.
With a RR of 5%, the Bank of Bankland must only hold $50,000 in cash. So what happens to the rest? It gets invested or loaned out. This is how banks make money.
You deposit money into your account, and banks do what they want with the vast majority, allowing them to gain interest or earn a return on investment.
The reserve ratio assumes that only a small portion of bank depositors will withdraw daily. This allows a bank to hold only enough for these daily withdrawals, along with some extra, in case of tremendous leaves.
Why is there a reserve ratio?
Some countries have legal requirements for reserve ratios. The eurozone (all countries that use the euro) and Argentina are prime examples. In the eurozone, a relatively stable area, RR is 1%.
In comparison, Argentina, a country in economic turmoil, has a RR of 44%. Exactly why these stark differences exist will be covered later, but for now, all you need to know is that these differences exist.
At the most basic level, a legally required reserve ratio is insurance in the case of a bank run, a large withdrawal in funds from bank accounts. Generally, these occur, ironically, when depositors have fears about a bank's ability to pay back deposited funds.
If a bank run occurs and some cannot withdraw funds immediately, panic ensues, and the bank run can worsen, spiraling out of control.
If banks have too much money tied up in illiquid assets and a bank run occurs, banks can default, causing substantial economic damage.
How does the reserve ratio affect the economy?
As previously mentioned, it at least partially helps reduce the likelihood of a severe bank run. There is, however, a much more impactful economic reason a governing body would choose to raise or decrease the required ratio.
A change in the ratio can significantly impact the money supply, affecting economic growth and inflation.
We must first know how the money multiplier works to understand the effects of a decrease or increase in the reserve ratio.
The money multiplier helps to define, quantitatively, what an increase in the RR by 10%, for example, would do to the money supply.
By understanding the money multiplier, a concept in economic theory, we can calculate how exactly the RR affects the economy.
Ultimately, we will be able to combine these factors to explain one of the many forms of monetary policy central banks use to shape the economy's growth.
The money multiplier describes how many dollars are produced in the economy when one dollar is minted.
Your instinct might be that $1 minted results in $1 in the economy. This, however, is not the case since banks keep less than 100% of all account deposits.
To calculate the amount a bank can loan out for each deposit made, the equation "1-RR * deposit = new loanable funds" is used, where RR is the reserve ratio.
Here's an example of this concept demonstrated through a bank with a 25% RR:
- Person A deposits $100
- The bank takes in that $100 and loans out $75 (1-.25 * 100 = 75)
- Person B takes out a loan and spends $75 at Person C's company
- Person C deposits $75
- The bank takes in that $75 and loans out $56.25 (1-.25 * 75 = 56.25)
- This cycle continues until $0 is loaned out
As you can see, $100 becomes many times larger due to the banking system.
To find out just how much bigger money will get, we use the money multiplier with the formula:
1/Required RR = Money Multiplier
This equation is heavily simplified, ignoring taxes, the fact that some funds aren't saved in bank accounts, etc. For our purposes, however, it works well enough.
Going back to our example, with an RR of .25, we can calculate how much more significant than $100 got.
Through the money multiplier equation of "1/.25 = 4", we find the money will grow four times its initial size. Therefore, the $100 new dollars would result in a $400 increase in the money supply.
Now that we understand the money multiplier, we can move to the effects of an increase or decrease in RR.
Decrease in the reserve ratio
A decrease in RR decreases the amount of money a bank has to hold, increasing the total amount of funds in an economy as more will be loaned out.
Our formulas back this up as well. Using our money multiplier formula: "1/required RR", inputting an RR of .5 renders a money multiplier of 2. Decreasing the RR to .1, the money multiplier becomes 10.
So why does it matter if decreasing the RR increases the amount of money? If an economy is underperforming, an increase in the money supply will act as a driver of economic activity and encourage growth.
However, this increases the risk of inflation should the money supply grow faster than the economic output of the economy.
Combining all this information, if a central bank wants to stimulate economic growth, it can decrease the RR, effectively increasing the money supply.
This allows a central bank to reign in a recession and encourages price stability, one of the main goals of modern central banks.
When calculating a company's future cash flows, possible RR changes should be considered due to the ratio's effect on the economy.
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Increase in the reserve ratio
Now we will look at the alternative case of a change in RR; an increase. This entails increasing the portion of the money that a bank must hold from every deposit.
Returning to the money multiplier formula, "1/RR," we can see the same effect in reverse.
By shifting a required RR of .1 to .5, the money multiplier decreases from 10 to 2.
This means that pre-shift, a dollar increase in circulation would create ten dollars in the economy. In comparison, a dollar in the post-shift economy will only increase the money supply by two dollars.
Now we can use this idea as the basis for monetary policy. When would we want a decrease in the money supply? When there is high inflation and an overheating economy.
In this case, the central bank can increase the required RR, effectively decreasing the money supply, cooling off the economy, and reducing inflation.
Why does the reserve ratio vary across nations?
The reasons and effects of decreasing or increasing the RR have been laid out. With this understanding, we can now move to why there is such a discrepancy between the reserve ratios of a place like the eurozone and Argentina.
The eurozone has seen steady, low inflation and relatively strong economies, excluding countries like Greece still recovering from the Great Recession.
The goal of approximately 2% inflation yearly has been hit reliably. Backing up economic theory, RR stands at a reasonably low point, with the current money supply sufficing for its inflation targets.
In comparison, Argentina has seen inflation averaging over 40% yearly. Again, in line with the economic theory, Argentina's RR is the highest globally at 44%.
The money supply is decreased through this high RR, and the Central Bank of Argentina is attempting to reign in this astronomical inflation.
Interestingly, countries like Canada and the United States now have no reserve ratio requirement.
The banks of these nations do not have to adhere to an RR, but there are still many other laws dictating their asset mix.
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Researched and authored by James Fazeli-Sinaki | LinkedIn
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