Effects of the cash ratio

The effects of the cash ratio originate as a result of the regulations of the Central Bankof 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, they have in their offices to meet the liquidity needs of their customers, plus the deposits that They keep in the Central Bank.

Legal reserves (RL) are also called cash assets of the banking system or bank reserve.

Legal reserves (RL) are part of the Monetary Base (BM), which is the value of all assets and currencies held by 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 a monetary control instrument. For reasons of prudence, the required reserves are also established to ensure that banks have sufficient  liquidity  at hand to meet the needs of their depositors. However, it is normal for banks not to have extraordinary reserves or RE, since they invest the excess liquidity (RE) in  treasury bills ,  corporate promissory notes , interbank loans or treasury bonds.

Then, such surplus reserves will cease to be 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; Normally, demand deposits have a higher required reserve ratio than term or savings deposits.

The minimum cash or reserve 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%.

  • 2% applies to most bank deposits, such as demand deposits with a maturity of less than 2 years and money market assets or easily convertible into money.
  • For deposits with a maturity of more than 2 years, a minimum percentage of reserve coefficient is applied.

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 save part of their money to guarantee their clients’ deposits. This situation usually occurs in times of financial crisis to avoid the risk of contagion among banks and balance the balance between the issuance of loans and the collection of deposits, which are its main business. We must remember that banks tend to operate very leveraged since they live from the fundraising by people.
  • This effect is related to a  contractive monetary policy, which consists in  raising the  intervention interest rates or interbank rate , with the objective of raising the reserves / deposits coefficient, by making loans more expensive if there are insufficient reserves. 

Effects of a decrease in the cash ratio

  • A drop in the cash ratio allows banks to develop their activity more freely and lend more to the public, encouraging 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, we must provide less legal reserves to cover customer deposits.
  • A decrease in the cash ratiois related to an  expansionary monetary policy , which consists in the modification of interest rates downwards,  with the purpose of reducing the financing cost of companies, while promoting private investment.

In this way, the bank can contribute or remove 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 any given time 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 the financial markets, an increase in the cash ratio to the Banks results in the existence of a lower amount of money in circulation and, therefore, people will have less access to credit and investment.

Example

Suppose we go to our bank and the cash ratio of this is 2%, imposed by the Central Bank.

If we decide to deposit 1,000 euros in our bank, you will have to provide 20 euros in your reservations, 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 are € 1,000 of the bank deposit and on the other 980 in cash. If the person who obtained this loan went to another financial institution to deposit those € 980, the process would be repeated. The bank would stay 2% and lend € 960.4 creating more money.

The process could be repeated successively until more money could be created thanks to the action of the legal cash ratio that prevents money from multiplying out of control.

It is important to mention that these reserves will be remunerated by the Central Bank for the so-called deposit facility , but at a lower interest rate than the market. In this way, since that part is remunerated at a lower interest rate, our bank will be obliged to charge higher rates of its resources in order to obtain, at least, the same profitability assuming that it could dispose of all its cash.

Leave a Comment