Reserve Ratio

The reserve ratio is the portion of reservable liabilities that commercial banks must hold onto, rather than lend out or invest. This is a requirement determined by the country's central bank, which in the United States is the Federal Reserve. It is also known as the cash reserve ratio.

The minimum amount of reserves that a bank must hold on to is referred to as the reserve requirement, and is sometimes used synonymously with the reserve ratio. The reserve ratio is specified by the Federal Reserve Board’s Regulation D. Regulation D created a set of uniform reserve requirements for all depository institutions with transaction accounts, and requires banks to provide regular reports to the Federal Reserve. The Formula for the Reserve Ratio

Reserve Requirement=Deposits×Reserve Ratio​.

As a simplistic example, assume the Federal Reserve determined the reserve ratio to be 11 per cent. This means if a bank has deposits of $1 billion, it is required to have $110 million on reserve ($1 billion x .11 = $110 million). The Federal Reserve uses the reserve ratio as one of its key monetary policy tools. The Fed may choose to lower the reserve ratio to increase the money supply in the economy. A lower reserve ratio requirement gives banks more money to lend, at lower interest rates, which makes borrowing more attractive to customers.

Conversely, the Fed increases the reserve ratio requirement to reduce the amount of funds banks have to lend. The Fed uses this mechanism to reduce the supply of money in the economy and control inflation by slowing the economy down.

The Fed also sets reserve ratios to ensure that banks have money on hand to prevent them from running out of cash in the event of panicked depositors wanting to make mass withdrawals. If a bank doesn't have the funds to meet its reserve, it can borrow funds from the Fed to satisfy the requirement.

Banks must hold reserves either as cash in their vaults or as deposits with a Federal Reserve Bank. On Oct. 1, 2008, the Federal Reserve began paying interest to banks on these reserves. This rate was referred to as the interest rate on required reserves (IORR). There was also an interest rate on excess reserves (IOER), which is paid on any funds a bank deposits with the Federal Reserve in excess of their reserve requirement. On July 19, 2021, the IORR and IOER were replaced with a new simplified measure, the interest on reserve balances (IORB). As of 2022, the IORB rate is 0.10%.

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