What is a Bank Reserve Ratio?

Bank Reserve Ratios and What They Mean

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Bank reserve ratios are central bank level regulations that set the minimum capital reserves that a commercial bank must hold as a percentage of its deposits and notes. The bank reserve ratio is also sometimes referred to as the cash reserve ratio (CRR) or bank reserve requirement. Often times, the bank reserve ratio is used as a monetary policy tool, since the regulations effectively change the amount of freely available funds for banks 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 crisis. 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.

In this article, we will look at the effects of bank reserve ratios on monetary policy, as well as how these policies impact international investors holding stocks and bonds.

Effects on Monetary Policy

Many Western countries avoid changing reserve requirements, since it could cause an immediate liquidity problem or banks with low excess reserves. Instead, these countries 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 0% on time deposits for many years.

The use of reserve ratios in monetary policy is instead most common in emerging markets. Countries like China have used reserve requirements as a way to combat inflation by raising them for its banks and reducing the available money supply. In fact, the country used the strategy extensively throughout the global economic decline in 2007 and 2010 to encourage and discourage lending.

For example, a bank with $10 million in deposits must hold $1 million in reserves, if the bank reserve ratio is 10%. This means that only $9 million is available to be lent out in the form of bank loans. Lowering the bank reserve ratio therefore increases the amount of money available to be loaned in the banking system and vice versa for an increase 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 United States and many other developed markets.

Effects on Stocks & Bonds

Bank reserve ratios are commonly used to affect monetary policy, which means they have a pronounced effect on stocks and bonds. Raising reserve requirements reduces the number of loans being made by banks, which shrinks the money supply, raises interest rates and reduces the volume of purchasing on credit in an economy. In contrast, lowering the reserve requirement enables banks to make more loans, which expands the money supply, lowers interest rates and increases consumer spending.

The effect on stocks and bonds is largely an indirect result of interest rates.

Higher interest rates tend to hurt bondholders, since interest rates are inversely correlated with bond prices. Meanwhile, 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, while lowering reserve requirements generally helps stocks and bonds. Meanwhile, higher reserve requirements generally come during times of inflation, while lower reserve requirements typically come during deflationary times.

International investors should keep these dynamics in mind when investing in countries that employ reserve ratios as a monetary policy tool, such as China

Key Takeaway Points

  • Bank reserve ratios are central bank regulations that set the minimum reserves that a commercial bank must hold as a percentage of its deposits and notes.
  • Reserve requirements are designed to help shield the banking system from sudden drops in liquidity that can result from a number of financial crisis.
  • Bank reserve ratios are commonly used to affect monetary policy, which means they have a pronounced effect on stocks and bonds.
  • Raising reserve requirements generally hurts both stocks and bonds, while lowering reserve requirements generally helps stocks and bonds.