Investing for Beginners , investing

Reserve ratio (reserve requirement or cash reserve ratio) is a ratio that is used by central bank of an area to regulate the financial market. This financial ratio compares the cash of the bank to the deposits that are held in that particular bank. Cash of the bank is recognized as physical cash held by bank and deposits (assets) of the commercial bank that are held in the central bank while these are the most liquid assets of the commercial bank. 

Central bank sets the minimum ‘reserve ratio’ and all the commercial banks in that country have to follow this minimum requirement. Higher reserve ratio means higher liquidity (short-term stability) of the bank but also may lead to lower profitability because such cash assets usually are least profitable for the bank. 

The central bank may change reserve requirement because of few reasons:

• There is a need to change the stability of the financial system. If a central bank sees that commercial banks need to accumulate the stability while financial markets are at risk, it may increase ‘reserve requirement ratio’ and ‘capital adequacy ratio’. 

• There is a need to make an influence to the economy. Banking system has huge impact to the overall economy as they work as money supply multiplier. By regulating reserve ratio central banks impact the overall money supply which helps to regulate economic cycles and inflation.

However, reserve ratio is more often manipulated in emerging market than in developed ones where financial market is at more sensitive balance.