What is Cash Reserve Ratio?
In the parlance of the commercial banking system, the cash reserve ratio denotes the proportion of overall deposits that a bank is required to retain with the central bank of the country. The proportion of bank deposit that has to be maintained with the central bank is also determined by the central bank itself. In some cases, the amount of reserve is decided based on the past experience of the central banks in each region during instances of a bank run i.e. when a large number of depositors withdraw their deposits at the same time. The Federal Reserve is the central bank for the United States, while it is Bank of England for the United Kingdom.
A bank is mandated to maintain the CRR to avert any shortage of funds during instances of bank run. Inherently, the central banks use the CRR as a means to manage liquidity in the economy by controlling the money supply. For example, the central bank will increase the CRR and shrink bank lending to control money supply in the market in case of a Contractionary Monetary Policy. On the other hand, the central bank will reduce the CRR and add to the market liquidity in case of an Expansionary Monetary Policy.
Cash Reserve Ratio Formula:
The formula for the cash reserve ratio is fairly simple and it can be derived by dividing the cash reserve that the bank is obligated to maintain with the central bank by the overall bank deposits.
Mathematically, it is represented as:
Examples of Cash Reserve Ratio (With Excel Template)
Let’s take an example to understand the calculation of the Cash Reserve in a better manner.
Example #1
Let us take the example of an economy where the central bank has decided on a Contractionary Monetary Policy and as such it has raised the cash reserve ratio from 4.5% to 5.5% in order to reduce money in the market. Now as per the new regime, Calculate the additional reserve required by a bank with overall bank deposits of $200 million.
Solution:
Additional Cash Reserve Requirement is calculated by using the formula given below:
Additional Reserve Requirement = (New Cash Reserve Ratio – Old Cash Reserve Ratio) * Bank Deposits
- Additional Reserve Requirement = (5.5% – 4.5%) * $200 million
- Additional Reserve Requirement = $2 million
Therefore, in this way the central bank has reduced the money supply to the tune of $2 million in the case of this bank per se.
Example #2
Let us take the example of bank ASZ Ltd that is located in the US. The bank has net transaction accounts of $150 million and it wants to calculate its cash reserve requirement according to the newly chartered reserve requirement by the Federal Reserve. As per the new rule, net transaction accounts of less than $16.3 million is exempted from any requirement, net transaction accounts of more than $16.3 million and less than $124.2 million will attract 3% reserve requirement and net transaction accounts of more than $124.2 million will be subjected to a 10% reserve requirement. Calculate the reserve requirement of ASZ Ltd.for ASZ Ltd can be.
Solution:
Cash Reserve Requirement for ASZ Ltd is calculated as:
- Reserve Requirement = $16.3 million * 0% + ($124.2 million – $16.3 million) * 3% + ($150 million – $124.2 million) * 10%
- Reserve Requirement = $5.82 million
Therefore, ASZ Ltd needs to maintain a cash reserve of $5.82 million with the Federal Reserve according to the new regulations.
Example #3
Let us now take the latest annual report of Bank of America to understand the concept of cash reserve ratio in the context of real life. According to the annual report of 2018, the overall deposits of the bank stood at $1,381.48billion on the balance sheet. Calculate the cash reserve requirement of Bank of America for the year 2018.
Since the bank has the majority of its liabilities in the US, we will consider the reserve requirement of the Federal Reserve for ease of calculation.
Solution:
Cash Reserve Requirement of Bank of America is calculated as:
- Reserve Requirement = $0.016 billion * 0% + ($0.124 billion – $0.016 billion) * 3% + ($1,381.48 billion – $0.124 billion) * 10%
- Reserve Requirement = $138.14 billion.
Therefore, for the year 2018, Bank of America is mandated to maintain a cash reserve of $138.14 billion which fairly close to the highlighted value of $148.34 billion maintained under Assets.
Advantages and Disadvantages of Cash Reserve Ratio
Advantages and disadvantages of CRR are as follows:
Advantages:
- The cash reserve ratio is primarily useful in controlling the money supply in the system by fostering a smooth money supply along with credit in the economy.
- The cash reserve ratio helps in developing a sustainable solvency position of the commercial banking system in an economy.
Disadvantages:
- When it is raised to make banks hold larger deposits in the Federal Reserve, it eventually results in an increased cost of borrowing for banks.
- Frequent changes in it can result in an uncertain economic environment for commercial banks.
Conclusion
So, it can be seen that the cash reserve ratio is a means to manage the liquidity of the commercial banks to maintain a sustainable and smooth banking system in an economy.
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