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What is a Reserve Ratio?
A reserve ratio is the amount of money that a bank must keep on hand, as a percentage of its customers’ deposits. Each country’s central bank determines what the ratio will be for the banks in that country. The money can be kept at the bank itself or in the nearest central bank location. Sometimes this number is called a cash reserve ratio (CRR). The reserve ratio is one of the three major tools of monetary policy, along with the discount rate and open market operations.
The reserve requirements are calculated by multiplying the bank’s book balance, or total deposits on the bank's books, by the reserve ratio. If a bank has $100 million (USD) in deposits on its books, and the reserve ratio is 10 percent, the reserve requirement is $10 million (USD). This means that the bank can lend out $90 million (USD) to its customers.
As the central bank of the United States, the Federal Reserve Bank sets the ratio in the United States and can change it as economic conditions warrant. Since the reserve ratio affects the money supply, the Federal Reserve Bank can adjust the rate to effect changes in economic policy. A change in the ratio can have a significant impact on interest rates and inflation, so changes are made only rarely, and in small increments.
The effect of changing the reserve ratio is called the multiplier effect. A decrease in the ratio means that banks have more money to lend. The loaned money is then deposited in another institution, which can then loan a higher percentage of that money, and so on, multiplying the amount of interest that banks can earn on the original deposit. Conversely, an increase in the ratio results in less money to lend and has the effect of tightening the money supply.
The importance of having a reserve ratio was illustrated in the United States during the Great Depression. Because of the free-fall in the stock market, many people decided that their money was not safe in the bank, so they tried, en masse, to withdraw their deposits. The banks did not have enough cash in reserve to pay all of the depositors, resulting in a ‘run on the bank.’ The government had to step in and declare a bank holiday to give the banks enough time to generate the required cash, and many banks that were unable to do so failed.
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![The Federal Reserve Bank sets the reserve ratio in the United States.]()
By: adamparentThe Federal Reserve Bank sets the reserve ratio in the United States. -
![The reserve ratio, set by the Federal Reserve, is the amount of money that a bank musts keep on hand, as a percentage of customer deposits.]()
By: Aaron KohrThe reserve ratio, set by the Federal Reserve, is the amount of money that a bank musts keep on hand, as a percentage of customer deposits.
Discussion Comments
@SkyWhisperer - Well, we’ve had many economic crises since the Great Depression and we’ve never seen massive runs on banks.
Frankly, banks are more likely to fail because of bad business practices than they are because of a run by the masses. Your money is insured, however, to $100,000 I believe.
If you are lucky enough to have more than that, you can spread your risk by depositing it in several banks.
I believe it was Thomas Jefferson who said that banks are more dangerous to our freedoms than standing armies. While I can’t say that I totally agree with that sentiment, I can’t say that I totally disagree either.
The reserve ratio is a case in point. By needing only one-tenth of your deposits on hand, as the article points out, the banks are in one sense gambling with our assets.
Of course you could put your money in a CD, which should get you some security, but still, a massive run on the bank would freeze you out of your money.
Don’t think that “runs” can’t happen today like they did in Great Depression day, either. All it takes is mass fear and hysteria about the economy, a huge collapse on Wall Street, and everyone will be in a frenzy to take out their money.
My father-in-law doesn't trust banks, so he keeps all his cash in a fireproof lock box. I have tried to explain the reserve ratio requirements to him, but it doesn't help.
I have even told him that his money will be insured by the FDIC up to a certain amount, but he still won't put his trust in any bank. He has quite a bit of savings, and he thinks that the lock box is the safest place to keep his wealth.
He used to keep the money box in his bedroom, and though it would be safe in the event of a fire, I pointed out to him that a tornado could easily whisk it away. Instead of moving it into a bank account, he moved the box to the basement.
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