Reserve Ratio

The reserve ratio is the portion of reservable liabilities (deposits) that commercial banks must keep on hand, rather than lend out or invest, at all times. The reserve ratio determines the money multiplier for an economy. Higher reserve ratios will lower the amount of money that a bank can make. Lower reserve ratios allow banks to make more loans and rehypothecate more deposits, which governments believe will encourage economic growth.

Governments and central banks often institute requirements for minimum reserve ratios. This limits the amount of money that can be lent out relative to the bank’s liabilities. A bank will generally lend out as much money as possible and set their actual reserve ratio as close to the required reserve ratio as possible, in order to maximize its revenue through interest payments. During periods of great uncertainty or debt destruction, banks diverge from this pattern and choose to hold higher reserve ratios than required by governments.