Bank Reserve Ratios and What They Mean
Bank reserve ratios are central bank regulations that set the minimum capital reserves that a commercial bank must hold as a percentage of its deposits. The bank reserve ratio is also sometimes referred to as the cash reserve ratio (CRR) or bank reserve requirement.
The bank reserve ratio is often used as a monetary policy tool since the regulations adjust the available funds that banks have to make loans. Reserve requirements are also designed to help shield the banking system from sudden drops in liquidity that can result from a number of financial crises. While some countries, like the U.K. and Australia, have no reserve requirements, others—like Brazil—have 20% reserve requirements, while Lebanon has 30% reserve requirements for its banking system.
Investors should be cognizant of the differences in bank reserve ratios across different countries and the propensity for their central banks to adjust them.
Effects on Monetary Policy
Many Western countries avoid changing reserve requirements since it could cause an immediate liquidity problem or banks to have low excess reserves. These countries instead utilize open-market operations, such as quantitative easing, to implement their monetary policy. The reserve ratio in the U.S. has been set at 10% for transactional deposits and zero percent on time deposits for many years. However, in response to the global COVID-19 pandemic, "the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions."
The use of reserve ratios in monetary policy is more common in emerging markets. For example, China has used reserve requirements as a way to combat inflation, since raising them reduces the available money supply. In fact, China had used the strategy extensively throughout the global economic decline in 2007 and 2010 to encourage and discourage lending.
Let's take a look at an example of how the bank reserve ratio affects monetary policy:
A bank with $10 million in deposits must hold $1 million in reserves, if the bank reserve ratio is 10 percent, which means that only $9 million is available to be lent out in the form of bank loans. Lowering the bank reserve ratio has therefore increased the amount of money available to be loaned in the banking system, and vice versa when increasing in the bank reserve ratio.
The effectiveness of reserve ratios as a monetary policy tool is debatable, but there's little doubt that it has at least a moderate effect on the market in the short to medium-term. However, the use of reserve ratios has become mostly irrelevant in the U.S. and many other developed markets, as regulators have abandoned them in favor of quantitative easing and more indirect policy tools. These alternatives were extensively used during the 2008-2009 global financial crisis in the United States and Europe.
Effects on Stocks and Bonds
The effect of reserve ratio changes on stocks and bonds is largely the indirect result of changes to interest rates. Higher interest rates tend to hurt bondholders since interest rates are inversely correlated with bond prices. The stock market also tends to react negatively to higher interest rates since it becomes more expensive for companies to obtain financing.
As a result, raising reserve requirements generally hurts both stocks and bonds and lowering reserve requirements generally helps stocks and bonds. Higher reserve ratio requirements generally come during times of inflation, while lower reserve requirements typically come during deflationary times. This means that stocks already tend to have higher than historical valuations.
Certain sectors of the stock market may also be more vulnerable to changes in the reserve ratio. Most notably, financial institutions tend to suffer when the reserve ratio is increased since they can make fewer loans and generate less interest income. The opposite is true when the reserve ratio is decreased and more capital is freed up for lending and interest-generating activities. Some countries pay interest on bank reserve ratios to financial institutions, which could prove beneficial depending on the prevailing interest rates. The United States Federal Reserve pays a 0.10% interest rate on bank reserves, as of March 2020, which compensates banks for the lost interest income.
International investors should keep reserve ratio changes in mind when investing in countries that employ reserve ratios as a monetary policy tool, such as China. Often times, investors can predict changes to bank reserve ratios by looking at underlying macroeconomic trends in inflation. A country with rising inflation may be at risk for an increase in reserve ratios while a country with deflation could be in for a decrease in reserve ratio requirements.
Investors can hedge against these risks by ensuring that their portfolio is diversified across many different countries and regions. That way, an adverse change in the reserve ratio in one country won't have a dramatic impact on the entire portfolio. Investors can also consider shifting their exposure into sectors that are less affected by reserve ratios and away from sectors that may be overexposed - such as the financial sector and commercial banks.