What is the cash ratio?

En financial terms the cash ratio is a percentage that is calculated on the total of the deposits that a financial institution has, such as a bank or savings bank. This percentage must be kept by financial institutions in a liquid state and kept on a mandatory basis at the central bank of each country, such as the Bank of Spain.

Usually the benches and savings banks quickly mobilize the money that their clients deposit in the entity, since keeping it fully immobilized would entail a high cost of maintenance and security. Most of that money is used by the financial institution in order to obtain a higher profitability, investing in bonos and securities or using it to grant loans, Mortgages and various financing products.

The cash ratio is also known as the reserve ratio or the ratio of bank lace. It is defined as the amount of minimum reserves that a bank or savings bank must have, which means that financial institutions cannot invest or lend that amount and must keep it to avoid liquidity failures or risk of bankruptcyThe main function of the cash ratio being precisely that, preventing bankruptcy of the banking system and guaranteeing the short-term solvency of financial institutions.

Calculation of the cash ratio

The value of the cash ratio is defined by the European Central Bank for all eurozone countries, establishing the minimum percentage of reserves that all financial institutions must maintain. Currently in the euro area, the percentage applied as a cash ratio is 1%, which means that financial institutions must keep 1% of the balances on certain types of liabilities held at the end of each month in a liquid state.

Effects of changes in the cash ratio

As with the interest rates or any decision made by the Central Banks, the variations that are made on the cash ratio have their consequences on the economy. Therefore, it is interesting to know what can happen in the event that the coefficient of banks increases or decreases.

To begin with, we must bear in mind that the increase in the cash ratio translates into the reduction of the money that exists in circulation. It is logical, since if banks have a certain amount of money and they have to accumulate a higher percentage to increase their minimum reserves, they will have less money to offer in the form of credit.

It is very normal to find this type of decision at times of recession or crisis, with the aim that the banks are not infected by the economic situation and a balance is produced between the credit they give and the money they receive. These decisions are usually accompanied by an increase in interest rates, to make the loan more expensive and to increase the banks' reserves.

While these decisions are made for policies of contraction of the economy, the drop in cash ratios is associated with expansion policies, since the good economic situation does not force banks to have such large reserves of money and allows them act with greater freedom. This causes that there is a greater amount of money that circulates in the economy, which contributes a greater dynamism. In this way, credit is favored that allows consumption and investment to reactivate the economic flow.

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