The effects of the cash ratio originate as a consequence of the regulations of the central bank of each country, which stipulates the required reserves that banks must maintain as a proportion of their deposits .
We must remember that the cash ratio is the percentage of deposits that banks must keep in the form of legal reserves. In turn, generally, it is usually made up of the banknotes and coins that are in the banking system, that is, banks and savings banks, have in their offices to meet the liquidity needs of their clients, plus the deposits that kept in the Central Bank.
Legal reserves (RL) are also called cash assets of the banking system or bank reserve requirements.
Legal reserves (RL) are part of the Monetary Base (BM), which is the value of all goods and currencies in the hands of the public (EMP) plus bank reserves (RB).
Bank reserves are expressed through the following formula:
BM = EMP + RB
The cash ratio has a crucial influence on bank credit, deposits and the supply of money or M3 (see monetary aggregates ). The central bank sets the cash ratio (required reserves or RE) as an instrument of monetary control. For reasons of prudence, the required reserves are also established to ensure that banks have sufficient liquidity on hand to meet the needs of their depositors. However, the normal thing is that banks do not have extraordinary reserves or ERs, since they invest the surplus liquidity (ER) in treasury bills , commercial paper , interbank loans or treasury bonds.
Then, such excess reserves will cease to be such and will become assets that will earn some interest. In some countries, reserve requirements also vary depending on the type of deposits the bank takes; demand deposits typically have a higher required reserve ratio than time or savings deposits.
The minimum reserve or cash ratio will be equal to or less than 10% of the deposits taken into account for its calculation. Currently, the average reserve level is 2%.
- The 2% applies to most bank deposits, such as demand deposits with a maturity of less than 2 years and assets on the money market or easily convertible into money.
- Deposits maturing in more than 2 years are subject to a or% minimum reserve ratio.
Effects of a rise in the cash ratio
- An increase in the cash ratio of commercial banks decreases the amount of money in circulation , because banks will keep part of their money to guarantee their customers’ deposits. This situation usually occurs in times of financial crisis to avoid the risk of contagion between banks and balance the balance between the issuance of loans and the collection of deposits, which are their main business. We must remember that banks tend to operate highly leveraged as they live off people’s fundraising.
- This effect is related to a contractionary monetary policy , which consists of raising the intervention or interbank interest rates , with the aim of raising the reserve / deposit ratio by making loans more expensive in the event of insufficient reserves.
Effects of a decrease in the cash ratio
- A decrease in the cash ratio allows banks to develop their activity more freely and to lend more to the public , promoting demand, consumption and the amount of money in circulation. This situation usually occurs in times of bonanza and credit expansion, since the financial situation of the economy is better and, therefore, fewer legal reserves must be provided to cover customer deposits.
- A drop in the cash ratio is related to an expansive monetary policy , which consists of modifying downward interest rates, in order to reduce the cost of financing companies, in turn promoting private investment.
In this way, the bank can contribute or take money from the market, the cash ratio being inversely proportional to the money multiplier. That is, if the Central Bank, as a monetary policy measure, decided at a certain point to raise the legal cash ratio, the amount of money that could be created would be lower (see how banks create money ), since banks are a higher percentage of the deposits they receive would remain.
In financial markets, an increase in the bank’s cash ratio has as a consequence the existence of a smaller amount of money in circulation and, therefore, people will have less access to credit and investment.
Suppose we go to our bank and its cash ratio is 2%, imposed by the Central Bank.
If we decide to deposit 1,000 euros in our bank, you will have to allocate 20 euros in your reserves, so the amount that the bank will have to lend to a third party will be € 980. With this operation the bank has already created money, since on the one hand there is € 1,000 of the bank deposit and on the other 980 in cash. If the person who has obtained this loan went to another financial institution to deposit those € 980, the process would be repeated. The bank would keep 2% and would lend € 960.4 creating more money.
The process could be repeated successively until no more money could be created thanks to the action of the legal cash ratio that prevents money from multiplying uncontrollably.
It is important to mention that these reserves will be remunerated by the Central Bank for the so-called deposit facility , but at an interest rate lower than the market rate. In this way, since that part is remunerated at a lower interest rate, our bank will be obliged to charge higher rates on its resources in order to obtain, at least, the same profitability assuming that it could have all its cash.
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