Reserve Ratio
IntermediateThe reserve ratio is the proportion of a bank's deposits that it holds as reserves, either as cash in its vaults or as deposits at the central bank, rather than lending out.
Banks do not keep all deposits as cash. They lend most of the money and hold only a fraction as reserves to meet day-to-day withdrawals. The reserve ratio measures that fraction.
For example, if a bank has 100 million of deposits and holds 10 million in reserves, its reserve ratio is 10%.
Some central banks set a minimum required reserve ratio as a policy tool. Raising it forces banks to hold more reserves and lend less, which can slow the economy. Lowering it frees up money for lending. In recent years, several major central banks have reduced or removed reserve requirements, relying instead on interest rates and liquidity rules to guide banking activity. Others still use reserve requirements actively.
The reserve ratio is linked to the idea of money creation in a fractional reserve banking system. When banks lend out deposits, the loans are spent and deposited elsewhere, allowing further lending. In practice, the amount of lending is also limited by capital requirements, demand for loans and central bank policy.
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