Banks make a profit by taking the money that consumers invest and loaning it out at a higher rate. However, banks must also keep a certain amount of cash on hand to cover their liabilities and financial obligations. The ratio of cash that a bank must have in liquid form is referred to as the reserve ratio and is regulated by the U.S. Federal Reserve.
Calculating Cash Reserve
The cash reserve ratio is the amount of cash on hand relative to total assets. To calculate a reserve ratio, divide cash reserves by the bank's total deposits. For example, say that a bank has total deposits of $100,000 and has $10,000 in current cash reserves. Its reserve ratio is $10,000 divided by $100,000, or 10 percent. If the required reserve ratio is 12 percent and total deposits are $100,000, the bank must maintain $12,000 in cash reserves instead of $10,000.
Effects of the Ratio
A high cash reserve ratio means banks have a lower chance of becoming insolvent and are able to pay when depositors withdraw cash. After the financial crisis of 2008, the Federal Reserve worked to increase liquidity and cash reserve requirements in banks.
However, a high cash reserve ratio also limits the amount of money a bank can lend out. Since banks earn money by lending cash, a high reserve requirement could decrease a bank's profits or force it to charge higher interest rates to make the same amount of profit. Since the amount that a bank can lend is dictated by reserve ratio requirements, central banks such as the Federal Reserve can also use these requirements as a type of monetary policy to control the supply of money in circulation.