reserve ratio and capital ratio
Reserve Ratio 💰
What is it?
The reserve ratio is the fraction of deposits that a bank must keep on hand as reserves.
Think of it like a safety deposit box: you keep a small amount of money in the bank so you can pay for emergencies.
Formula
Reserve Ratio = Reserves / Deposits
Example
| Reserves ($m) | Deposits ($m) | Reserve Ratio |
|---|---|---|
| 10 | 100 | 10% |
Impact on Money Supply
- Higher reserve ratio → banks lend less → money supply shrinks.
- Lower reserve ratio → banks lend more → money supply expands.
Capital Ratio 📈
What is it?
The capital ratio shows how much capital a bank has relative to the risk of its assets.
Imagine a safety net under a circus performer: the stronger the net, the safer the act.
Formula
Capital Ratio = Tier 1 Capital / Risk‑Weighted Assets
Example
| Tier 1 Capital ($m) | Risk‑Weighted Assets ($m) | Capital Ratio |
|---|---|---|
| 5 | 50 | 10% |
Why it matters
- Higher capital ratio → bank can absorb losses → more confidence from depositors.
- Regulators set minimum ratios to keep the financial system stable.
Exam Tips 📚
Remember: Use the formulae correctly and show the steps.
When asked about the effect of changing the reserve ratio, explain the chain: reserve ratio ↑ → lending ↓ → money supply ↓ → interest rates ↑.
For capital ratio questions, highlight the role of risk‑weighted assets and the regulatory minimums.
Use clear diagrams or tables to present your calculations.
Revision
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