reserve ratio and capital ratio

Money and Banking – Reserve Ratio and Capital Ratio (Cambridge AS‑A Economics 9708, Syllabus 9.4)

1. Money – Definition, Characteristics & Functions

• Definition: Money is any asset that is widely accepted as a medium of exchange for goods and services, a unit of account and a store of value.
• Key characteristics of money (Cambridge requirement):
  • Durability – it does not wear out quickly.
  • Portability – easy to carry and transfer.
  • Divisibility – can be broken into smaller units.
  • Acceptability – universally accepted in transactions.
  • Scarcity – limited supply relative to demand, giving it value.
• Functions of money
  • Medium of exchange – eliminates the need for a double‑coincidence of wants.
  • Unit of account – provides a common measure for valuing goods, services and assets.
  • Store of value – preserves purchasing power over time (subject to inflation).

2. Money‑Supply Measures

Measure	What it includes
M0	All physical currency (notes & coins) in circulation plus banks’ reserves held at the central bank.
M1	M0 + demand deposits (current accounts) + other liquid deposits that can be accessed immediately.
M2	M1 + savings deposits, time deposits (under £100 000) and other near‑money assets.

In the Cambridge syllabus the focus is on how the banking system creates M1 and M2 through credit creation.

3. The Quantity Theory of Money and the AD/AS Model

The quantity theory links the money supply to the price level and real output:

MV = PY

• V = velocity of money (average number of times a unit of money is spent in a period).
• In the short‑run V can change with interest rates and expectations; in the long‑run it is often assumed to be stable.
• Holding V and Y constant, an increase in M shifts the aggregate‑demand (AD) curve right (higher P or higher Y). Conversely, a fall in M shifts AD left.

4. The Role of the Central Bank

• Objectives: price‑stability, sustainable economic growth, financial‑system stability.
• Key monetary‑policy instruments (Cambridge expects students to name at least three):
  • Policy (base) interest rate – influences borrowing costs, the inter‑bank rate and ultimately the money‑demand curve.
  • Open‑market operations (OMO) – buying or selling government securities to change banks’ reserves and the money supply.
  • Reserve requirements (RR) – the proportion of deposits banks must hold as reserves.
  • Standing facilities – lender‑of‑last‑resort (discount window) and deposit facility.
  • Repo and reverse‑repo operations – short‑term collateralised lending to manage liquidity.
  • Quantitative easing (QE) – large‑scale asset purchases when policy rates are at the lower bound.
• Through these tools the central bank can influence:
  • The money multiplier (via RR).
  • The level of reserves in the banking system (via OMO, repos).
  • Interest rates and thus money‑demand (via the policy rate).

5. Functions of Commercial Banks

• Deposit‑taking (demand, savings and time deposits).
• Credit creation – each new loan creates a new deposit, expanding the money supply.
• Payments system – cheques, debit cards, electronic transfers, clearing.
• Liquidity management – hold cash and balances at the central bank to meet withdrawals.
• Risk management – maintain capital buffers to absorb losses (capital ratio).
• Inter‑bank market participation – borrowing/lending reserves, influencing the inter‑bank rate.

6. Reserve Ratio (RR)

6.1 Definition & Formula

The reserve ratio is the proportion of a bank’s deposit liabilities that must be held as liquid reserves.

RR = Reserves ÷ Deposit Liabilities

Reserves = cash in the vault + balances held at the central bank.

6.2 Numerical Example

Item	Amount (£ million)
Cash in vault	50
Balance at central bank	150
Total reserves	200
Customer deposits	1,000
Reserve ratio	0.20 (20 %)

6.3 Money‑Multiplier Relationship

In a simple fractional‑reserve system (ignoring excess reserves and currency leakage):

Money multiplier (m) = 1 ÷ RR

With RR = 20 %, m = 5. A change in RR therefore changes the multiplier and the potential size of the money supply.

6.4 Policy Implications (AO2)

• Increasing RR – reduces the multiplier, contracts credit, raises interest rates, and can help curb inflation (AD shifts left).
• Decreasing RR – expands the multiplier, stimulates credit growth, lowers interest rates and can support output in a recession (AD shifts right).
• Reserve requirements are a blunt tool; many advanced economies use them mainly as a floor for the inter‑bank rate while relying on OMO and the policy rate for fine‑tuning.

6.5 Evaluation (AO3)

• Advantages – simple to understand; provides an immediate check on bank liquidity; useful in a crisis to force banks to hold more cash.
• Disadvantages – can cause large, abrupt swings in credit supply; banks may hold excess reserves, weakening the transmission mechanism; less precise than interest‑rate policy.
• Modern practice – e.g., the Bank of England keeps the reserve‑requirement ratio low (2 %) and primarily uses the policy rate and OMO to steer the economy.

7. Capital Ratio (CR)

7.1 Definition & Formula

The capital ratio measures a bank’s ability to absorb losses. Under Basel III the most widely used ratio is the Tier 1 capital ratio:

Tier 1 Capital Ratio = Tier 1 Capital ÷ Risk‑Weighted Assets (RWA)

7.2 Risk‑Weighted Assets – How They Are Calculated

Asset category	Nominal value (£ million)	Risk weight (%)	Risk‑weighted value (£ million)
Cash & reserves	200	0	0
Government bonds	300	0	0
Mortgage loans	500	50	250
Unsecured personal loans	400	100	400
Total RWA			650
Tier 1 Capital (equity + disclosed reserves)	130
Tier 1 Capital Ratio	0.20 (20 %)

7.3 Basel III Minimum Requirements (AO1)

• Tier 1 capital ratio ≥ 6 %.
• Total capital ratio (Tier 1 + Tier 2) ≥ 8 %.
• Capital Conservation Buffer = 2.5 % (adds to the minimum).
• Counter‑Cyclical Buffer = 0‑2.5 % (activated in credit‑boom periods).
• Leverage ratio (Tier 1 capital ÷ total exposure) ≥ 3 % (a non‑risk‑weighted safeguard).

7.4 How Capital Requirements Influence Credit (AO2)

• Higher CR forces banks to hold more equity relative to risk‑weighted assets, reducing the amount of credit they can extend for a given capital base.
• Lower CR encourages banks to increase risky lending, potentially expanding the money supply but also raising systemic risk.
• Changes in CR affect the supply of loanable funds and can shift the credit‑supply curve upward (higher interest rates) or downward (lower rates).

7.5 Evaluation (AO3)

• Why Basel III? – Introduced after the 2008 crisis to address under‑capitalisation, improve loss‑absorbing capacity and reduce pro‑cyclical lending.
• Trade‑offs – Stronger buffers enhance stability but may raise the cost of credit, slow growth, and push risk‑taking into the shadow‑bank sector.
• Effectiveness – Empirical evidence shows higher capital ratios reduce bank‑failure probability; however, the impact on the overall money supply is indirect compared with reserve‑ratio changes.

8. Money‑Demand Theory and Interest‑Rate Determination (AO2)

8.1 Liquidity‑Preference (Keynesian) View

• Demand for money (L) is a function of real income (Y) and the nominal interest rate (i): L = f(Y, i).
• Higher Y → higher transaction demand for money.
• Higher i → higher opportunity cost of holding money → lower demand (more is held as bonds).
• Shift in L moves the LM curve; the intersection with the IS curve determines the equilibrium interest rate and output.

8.2 Loanable‑Funds (Classical) View

• Savers supply funds; borrowers demand funds. The real interest rate equilibrates supply and demand.
• Changes in RR or CR shift the supply of loanable funds by altering how much banks can lend.
• Higher RR or CR reduces the supply of loanable funds, pushing the real interest rate up.

8.3 Interaction with Reserve and Capital Ratios

• Reserve‑ratio change – Directly alters the money multiplier, moving the LM curve (Keynesian) and changing the supply of loanable funds (Classical).
• Capital‑ratio change – Affects banks’ willingness to take on risk, shifting the credit‑supply curve; the effect on the interest rate is more gradual and operates through risk premia.

9. Integrating the Concepts – How RR and CR Affect the Economy

1. Reserve‑ratio adjustment – A rise in RR lowers the multiplier, contracts M1, shifts AD left, raises the policy rate (through the LM curve) and reduces investment and output in the short run.
2. Capital‑ratio tightening – Higher Tier 1 requirements force banks to hold more equity, contract credit, raise loan rates (risk premium) and dampen investment; systemic risk falls.
3. Both tools aim at financial stability but operate on different dimensions: RR controls liquidity, CR controls solvency.
4. In practice, advanced economies rely mainly on the policy rate and OMO for day‑to‑day management, using RR and CR as prudential safeguards.

10. Summary – Key Points for Revision (AO1)

• Money is a medium of exchange, unit of account and store of value; it possesses durability, portability, divisibility, acceptability and scarcity.
• Money‑supply measures: M0 (currency + central‑bank reserves), M1 (M0 + demand deposits), M2 (M1 + savings/time deposits).
• Quantity theory (MV = PY) links changes in the money supply to the price level and output; in the AD/AS framework an increase in M shifts AD right.
• Central‑bank objectives and tools: policy rate, open‑market operations, reserve requirements, repos, standing facilities and QE.
• Commercial banks create money by granting loans; their key functions are deposit‑taking, credit creation, payments, liquidity and risk management.
• Reserve ratio (RR = Reserves ÷ Deposit liabilities) determines the money multiplier (m = 1/RR). Raising RR contracts credit; lowering RR expands it.
• Capital ratio (Tier 1 Capital ÷ RWA) measures loss‑absorbing capacity. Basel III sets minimum ratios and buffers; higher CR reduces credit growth but improves stability.
• Money‑demand depends on income (Y) and the interest rate (i). The liquidity‑preference view gives the LM curve; the loanable‑funds view gives the IS‑LM interaction.
• Policy implications: RR influences liquidity and the money multiplier directly; CR influences banks’ risk‑taking and the credit‑supply curve indirectly.
• Evaluation: RR is simple but blunt; CR enhances solvency but can raise borrowing costs and push activity into the shadow‑bank sector.

• (a) The money‑multiplier process – show how a change in RR moves the LM curve and the AD curve.
• (b) Credit‑supply diagram – illustrate the effect of a higher capital ratio on loan interest rates and output.
• (c) AD/AS diagram – demonstrate how a change in the money supply (via RR or CR) shifts AD.