Variable Reserve Requirement (Cash and Liquidity Ratios)
The Central Bank controls the creation of credit by commercial banks by dictating cash and liquidity ratios. The cash ratio is:
The Central Bank might require the commercial banks to maintain a certain ratio, say 1/10. Hence:
Cash Reserves = 1
Deposits = 10 x Cash Reserves
This means that the banks can create deposits exceeding 8 times the value of its liquid assets. The liquidity ratio can be rewritten as:
Cash + Reserves Assets = Cash + Reserves Assets
Deposits Deposits Deposits
= Cash Ratio + Reserve Assets Ratio
If the liquidity ratio is 12.5, then:
Cash + Reserved Assets = 1
Deposits Deposits 8
Deposits = 10 x cash + 2.5 x Reserve Assets.
In most countries the Central Bank requires that commercial banks maintain a certain level of Liquidity Ratio i.e. Cash reserves (in their own vaults and on deposit with the Central Bank) well in excess of what normal prudence would dictate. This level shall be varied by the Central Bank depending on whether they want to increase money supply or decrease it.
This is potentially the most effective instrument of monetary control in less developed countries because the method is direct rather than via sales of securities or holding bank loans and advances. The effects are immediate. This method moreover does not require the existence of a capital market and a variety of financial assets. However, increased liquidity requirements may still be offset in part if the banks have access to credit from their parent companies. A further problem is that a variable reserve asset ratio is likely to be much more useful in restricting the expansion of credit and of the money supply than in expanding it: if there is a chronic shortage of credit-worthy borrowers, the desirable investment projects, reducing the required liquidity. Ratio of the banks may simply leave them with surplus liquidity and not cause them to expand credit. Finally, if the banks have substantial cash reserves the change in the legal ratio required may have to be very large.