What is the Reserve Ratio?
The reserve ratio is the percentage of deposits that the Federal Reserve requires a bank to keep on hand at a Federal Reserve Bank.
Reserve Ratio Example
For example, let's assume that Bank XYZ has $400 million in deposits. If the Federal Reserve's reserve ratio requirement is 10%, Bank XYZ must keep at least $40 million in an account at a cash for lending or any other purpose.
Reserve ratios are set by the Federal Reserve, the central bank of the U.S. It is a bank for banks. Its several branches around the U.S. hold deposits for and lend to banks. As a means of ensuring the safety of the nation's financial institutions, the Federal Reserve sets reserve ratios so that banks always have some on hand to prevent a run (a mass withdrawal of deposits so large that the bank actually runs out of cash, panicking the rest of the depositors). If a bank is unable to meet its reserve ratio, it can borrow from the Federal Reserve to meet the requirement.
Why Reserve Ratios Matter
Reserve ratios are a key component of monetary policy. The Federal Reserve can lower the reserve ratio, for example, in order to enact expansionary monetary policy and encourage economic growth. The reduction makes banks free to lend more of their deposits to other bank customers and earn interest.
These customers in turn deposit the loan proceeds in their own bank accounts, and the process continues indefinitely. This increase in the supply of available lowers the price of those (i.e., the lending rate), making debt cheaper and more enticing to borrowers.
If the Federal Reserve increases the reserve ratio (which leaves less of a bank's deposits available for lending), the reverse happens and the Federal Reserve can slow down the .