• Skip to primary navigation
  • Skip to main content
  • Skip to footer
WallStreetMojo

Wallstreet Mojo

Wallstreet Mojo

MENUMENU
  • Resources
        • Financial Statement Analysis

          • Ratio Analysis
          • Profitability Ratios
          • Turnover Ratios
        • Financial-Statement-Analysis
        • Accounting Basics

          • Income Statement
          • Balance Sheet
          • Cash Flow in Accounting
        • Accounting-Basics
        • Accounting Concepts

          • Assets in Accounting
          • Liabilities in Accounting
          • Shareholders Equity
        • Accounting-Concepts
        • Investment Banking Guides

          • Investment Banking
          • What is LBO?
          • What is Pitch Book?
        • Investment Banking Guides
        • Valuation

          • Discounted Cash Flow
          • Dividend Discount Model
          • Terminal Value
        • Valuation
        • Others

          • Resources (A to Z)
          • Financial Modeling
          • Financial Certifications
          • Equity Research
          • Private Equity
          • Excel
  • Free Courses
  • All Courses
        • Certification Courses

          Certificate
        • All in One Financial Analyst Bundle

          Financial-Analyst-Bundle
        • Accounting Course

          Accounting-Course
        • Investment Banking Course

          Investment-Banking-Training
        • Others

          • Equity Research Course
          • Financial Modeling Course
          • M&A Course
          • Valuation Course

          • Private Equity Course
          • Venture Capital Course
          • US GAAP Course
          • View All
  • 250+ Courses All in One Bundle
  • Login

Reserve Requirement

Home » Financial Statement Analysis » Liquidity Ratios » Reserve Requirement

By Pooja Borkar Leave a Comment

Reserve Requirement

Reserve Requirement Definition

Reserve Requirement, also known as the cash reserve ratio, is the liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.

It is mandated by central banks around the world for their member banks in order to regulate safety cash held by the banks. This cash reserve serves many different purposes in different economies. The Central bank of the United States is the Federal Bank which holds authority on this requirement in the United States. Similarly, the People’s Bank of China does a similar function for Chinese banks.

Components of Reserve Requirement

Reserve Requirement is a function of Net Demand and Time Liabilities (NDTL). NDTL is based on current deposits, saving deposits, term deposits, and other liabilities. This is also adjusted for the deposits from other banks. The formula for NDTL becomes:

NDTL = Demand liabilities + time liabilities + other demand and time liabilities – deposits with other banks

Reserve requirement calculation can be done by using Net demand and time liabilities.

Cash Reserve Ratio = Cash Reserve maintained with the Central Bank/Net demand and time liabilities.

Popular Course in this category
All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) 250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion
4.9 (1,067 ratings)
Course Price

View Course

Related Courses
Accounting CourseInvestment Banking CourseEquity Research Course

Examples of Reserve Requirements

Below are the given examples of reserve requirements to understand its calculation in a better manner.

You can download this Reserve Requirement Excel Template here – Reserve Requirement Excel Template

Example #1

Suppose that a bank named ABL in the United States is required by the Federal Reserve to maintain a 9.2% cash reserve. The Bank declares its net demand and time liabilities at $100 million. What is the amount of reserve that the bank will put in the Federal reserve?

Solution:

Since the federal reserve has a 9.2% regulation on cash reserve, it will be applicable to the net demand and time liabilities of the bank ABL. The bank will maintain a 9.2% of its NDTL $100 million in reserve.

Cash Reserve against NDTL

Reserve Requirement Example1

  • =$100*9.2%
  • =$9.2

Thus, it will maintain $9.2 million in the Federal Reserve vaults.

Example #2

A bank in Mexico, Smith and Sons Limited, has been mandated a reserve requirement of 7.5% of its net demand and time liabilities (NDTL). If it has the following liabilities (see table) on its balance sheet and an 80% can be attributed to the NDTL, do the calculation to get the amount it should be maintaining for reserve requirement?

Example 2

All figures are in US dollars.

Solution

The table above can be used to deduce total liabilities that the bank has on its balance sheet. The reserve requirement is a function of the net demand and time liabilities (NDTL) and thus, the latter can be obtained as a means of percentage of the total liabilities.

Total Liabilities & Net Demand and Time Liabilities

Example 2.1

  • Thus, total liabilities = $23 mn + $30 mn + $12 mn = $65 mn.

NDTL = 80% of total liabilities which is 80% of $65 mn

Reserve requirement = 5% of NDTL.

Amount Reserves

Example 2.2

  • =$3.9

So, the number of reserves the bank has to make with the central bank of Mexico = $3.9 mn.

Advantages

  • For a long time in the history of banking, reserve requirements helped Central banks to regulate the circulation of money. It is now deemed helpful in keeping interest rates (lending rates) under check. That said, Central banks do not necessarily mandate these rates but influence or impact them.
  • It also guides other rates which the banks use among themselves. For instance, the LIBOR – London Interbank Offered Rate.
  • It is also a measure to keep liquidity in the system under the scanner.
  • It can also be used as a tool for fighting inflation.

Limitations

  • Cash reserve ratio does not account for short-term funds and other marketable securities that are also considered highly liquid. Hence, it does not present a true picture of a bank’s liquidity.
  • An ill-managed reserve can cause a slowdown in the economy and/or haphazard measures by financial institutions.
  • Most economists in the modern era disagree with the notion of reserve requirement as controlling money circulation. They opine that with growing functionalities in the banking space reserve requirements have a lesser role to play in regulating money circulation.

Disadvantages

  • A continuous increase or decrease in reserve requirements may cause the spirit of investors to die down. reserve requirement sometimes becomes critical in investor circles.
  • These requirements are changed only when needed stringently because they can be expensive to implement.

Important Points

  • If the reserve requirement from the Central banks is high, the member banks make fewer profits because they have a higher amount in the custody of Central banks. Vice versa, the profits are high if the reserve requirement is less.
  • Banks borrow funds from the Federal Reserve as well as from each other. The funds that are borrowed and lent among the banks are known as Federal funds. And the interest rate that is charged is called the Fed funds rate.
  • Any financial institution that holds amounts that are in excess of the required reserves is said to have excess reserves.

Conclusion

Reserve requirements may not always serve its purpose. As could be seen during the financial crisis of 2008-09, the lower interest rates and lesser the requirements could not manifest into expansionary tactics as intended. It was because of general distrust which could not be compensated through reserve requirements.

Countries like the United States, India, and Japan are mandated by their Central banks – the Federal Reserve of the United States, Reserve Bank of India and Bank of Japan respectively for reserve requirements. For a liability of more than $124.2 million, the US Federal Reserve System requires banks to put aside 10% which is effective from Jan 17, 2019. The lower limit in the United States is $2 million below which financial institutions need not abide by any reserve requirement

In the past 2 decades, the Reserve Bank of India has averaged 5.41% on the account of the Cash reserve requirement. There are countries where there is no requirement to keep cash reserves. For example, Hong Kong, United Kingdom, and Australia are free from such requirement.

Recommended Articles

This has been a guide to Reserve Requirement and its definition. Here we discuss components of the reserve requirement and examples with calculation. You can learn more about accounting from the following articles –

  • Reserve Ratio Functioning
  • Formula of Cash Reserve Ratio
  • What is Retail Banking?
  • What is a Bad Bank?
  • Calculate Leverage Ratios Banks
6 Shares
Share
Tweet
Share

Filed Under: Financial Statement Analysis, Liquidity Ratios

Reader Interactions
Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Footer
COMPANY
About
Reviews
Blog
Contact
Privacy
Terms of Service
FREE COURSES
Free Finance Online Course
Free Accounting Online Course
Free Online Excel Course
Free VBA Course
Free Investment Banking Course
Free Financial Modeling Course
Free Ratio Analysis Course

CERTIFICATION COURSES
All Courses
Financial Analyst All in One Course
Investment Banking Course
Financial Modeling Course
Private Equity Course
Business Valuation Course
Equity Research Course
CFA Level 1 Course
CFA Level 2 Course
Venture Capital Course
Microsoft Excel Course
VBA Macros Course
Accounting Course
Advanced Excel Course
Fixed Income Course
RESOURCES
Investment Banking
Financial Modeling
Equity Research
Private Equity
Excel
Books
Certifications
Accounting
Asset Management
Risk Management

Copyright © 2019. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.
Return to top

WallStreetMojo

Free Ratio Analysis Course

Step by Step Guide to Calculating Financial Ratios in excel

By continuing above step, you agree to our Terms of Use and Privacy Policy.

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.
WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

* Please provide your correct email id. Login details for this Free course will be emailed to you

Download Colgate Ratio Analysis Template

By continuing above step, you agree to our Terms of Use and Privacy Policy.
WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

* Please provide your correct email id. Login details for this Free course will be emailed to you

WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

* Please provide your correct email id. Login details for this Free course will be emailed to you

WallStreetMojo

Download Reserve Requirement Excel Template

By continuing above step, you agree to our Terms of Use and Privacy Policy.

Limited Period Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More