Reserve Ratio and Capital Ratio

This section explores two crucial regulatory ratios in banking: the reserve ratio and the capital ratio. These ratios are vital for maintaining the stability and soundness of the banking system and protecting depositors.

Reserve Ratio

The reserve ratio is the fraction of a bank's deposits that they are required to keep in reserve, either as vault cash or on deposit with the central bank. It's a key tool used by central banks to control the money supply.

Calculation

The reserve ratio is calculated as:

$$ \text{Reserve Ratio} = \frac{\text{Reserves}}{\text{Deposits}} $$

Where:

• Reserves: The amount of money a bank holds in reserve.
• Deposits: The total amount of money deposited by customers.

Impact of Changes in the Reserve Ratio

1. Increase in Reserve Ratio: If the central bank increases the reserve ratio, banks must hold a larger portion of their deposits in reserve. This leaves less money available for lending, which reduces the money supply and can lead to higher interest rates.
2. Decrease in Reserve Ratio: Conversely, if the reserve ratio is decreased, banks are required to hold less in reserve. This frees up more money for lending, increasing the money supply and potentially lowering interest rates.

Example

If a bank has $100 million in deposits and the reserve ratio is 10%, the bank must hold $10 million in reserve and can lend out $90 million.

Capital Ratio

The capital ratio measures the amount of capital a bank holds in relation to its risk-weighted assets. Capital is the difference between a bank's assets and its liabilities. A high capital ratio indicates a bank's financial strength and ability to absorb losses.

Calculation

The capital ratio is calculated as:

$$ \text{Capital Ratio} = \frac{\text{Capital}}{\text{Risk-Weighted Assets}} $$

Where:

• Capital: This includes shareholders' equity and other forms of capital.
• Risk-Weighted Assets: Assets are assigned a risk weight based on their perceived riskiness. For example, government bonds have a low risk weight, while loans to businesses might have a higher risk weight.

Importance of Capital Ratios

1. Financial Stability: Capital ratios provide a buffer against unexpected losses. If a bank experiences losses, its capital can absorb those losses without becoming insolvent.
2. Depositor Protection: High capital ratios reassure depositors that the bank is financially sound and their deposits are safe.
3. Regulatory Requirements: Central banks typically set minimum capital ratio requirements for banks to ensure financial stability. These requirements are often specified by Basel Accords.

Basel Accords

The Basel Accords are a set of international banking regulations developed by the Basel Committee on Banking Supervision. They aim to improve financial stability by setting standards for capital adequacy, risk management, and other aspects of banking. Basel III, in particular, significantly increased the minimum capital requirements for banks.

Ratio	Description	Impact on Lending	Impact on Financial Stability
Reserve Ratio	Fraction of deposits banks must hold in reserve.	Higher ratio = Lower lending. Lower ratio = Higher lending.	Higher ratio = More stable banking system. Lower ratio = Potentially less stable.
Capital Ratio	Ratio of bank's capital to its risk-weighted assets.	Higher ratio = More capacity to absorb losses, supporting lending. Lower ratio = Reduced capacity to absorb losses, potentially limiting lending.	Higher ratio = More resilient to shocks. Lower ratio = More vulnerable to shocks.

These ratios are fundamental to understanding how central banks regulate the banking sector and maintain financial stability.