BNET Basics

Determining the Reserve Ratio

by BNET Editorial

Tags: bank, reserve, financial services

The reserve ratio (or reserve requirement) measures what proportion of a bank�s total deposits are held in reserve to meet withdrawal demands. In the United States, the rules about this are dictated by the Federal Reserve, while in the U.K. and some other countries in Europe, individual banks will use their own measures and targets.

The purpose of the reserve ratio is to protect banks from instability that could result from unexpected levels of debits. The number of transactions cleared through banks every day is so huge and unpredictable, that some kind of cushion is essential to ensure there are sufficient funds to honor them. Without such a reserve, banks and other depositories risk becoming overdrawn at the close of a day�s business, and liable to face penalties.

The introduction of reserve ratios has also had the effect of minimizing �bank runs� during financial crises�when depositors panic about the ability of a bank to honor its liabilities, and withdraw all their money at once.

What to Do

In Europe, banks base their reserve requirement on categories of reserve items set by the European Central Bank. Each institution calculates their particular requirement, by multiplying the reserve ratio for each category with the amount of those items they have on their own balance sheets.

In the U.S., the Federal Reserve Board specifies what percentage of its deposits a bank must keep in a non-interest-bearing account (at one of twelve Federal Reserve Banks around the country). This percentage depends on the level of checkable (easily transferable) deposits a particular bank holds. For example, for the first $44.3 million held, the bank must set aside 3% for a reserve. Above $44.3 million, the reserve requirement is 10%. Reserves are not required against savings accounts or certificates of deposit. The levels set are subject to annual review.

The percentage of its demand deposits that a bank may lend is also limited by the reserve ratio. For example, in the U.S., a bank must hold 10% of such deposits in reserve�so it may issue loans equal to 90%. Reserves can be held as cash or deposits in any proportion, at a Federal Reserve Bank.

If a bank�s reserves are likely to fall short of demands, it can take a number of steps:

borrow reserves from another bank for a day or two
raise money by trading saleable assets (like government stocks)
make a bid for money market funds
borrow reserves against its assets from the Federal Reserve.

Many banks avoid the need for such contingencies by keeping their reserves well above the required reserve ratio, providing additional safeguards in the event of high levels of withdrawals and overdrafts.

What You Need to Know

Reserves earn interest, so they cannot contribute to a bank�s earnings.
Although it reviews the reserve ratio annually, the U.S. Federal Reserve Board rarely adjusts it.
Reserves are held either in the form of cash in the Reserve Bank�s vaults, or as balances in Reserve accounts, which has a greater effect on monetary policy.