Reserve requirement cut, also known as a reduction in the required reserve ratio (RRR), refers to a policy action taken by the central bank to decrease the amount of reserves that commercial banks are obligated to hold.
What is a reserve requirement? Think of it as setting aside a portion of your monthly salary as emergency funds. Similarly, the reserve requirement for banks can be seen as their emergency funds.
The primary business of commercial banks is to attract deposits from savers and then lend out those funds to earn interest on loans. Naturally, banks want to maximize their profits.
However, they can not lend out all the deposits because if all funds are lent out and depositors want to withdraw their money, it would create significant problems.
To ensure that commercial banks have enough liquid funds to meet the withdrawal demands of depositors, the central bank establishes a special account called the reserve account to help banks manage this portion of liquid funds.
The proportion of funds that banks contribute to the reserve account is known as the required reserve ratio.
For example, let’s assume that the central bank sets a reserve requirement ratio of 10% during a specific period.
This means that for every 100 billion yuan collected by banks, 10 billion yuan is required to be transferred to the central bank and placed into the reserve account. The remaining 90 billion yuan can be used by the banks for lending.
If the central bank reduces the reserve requirement ratio from 10% to 8%, it means that the amount transferred to the central bank decreases to 8 billion yuan, and the banks now have an additional 2 billion yuan available for lending.
Of course, in practice, the central bank’s reserve requirement cuts are not typically that significant, usually ranging between 0.25% to 1%.
However, even such small adjustments can have a substantial impact when considering the vast circulation within the banking system, potentially resulting in hundreds of billions or even trillions of available investable funds in the market.
For banks, a reserve requirement cut increases their liquidity, lowers their funding costs, and enhances their willingness and ability to extend credit.
For businesses, it becomes easier to obtain credit support from financial institutions, and loan interest rates are expected to further decline, reducing financing costs. Additionally, a reserve requirement cut helps stabilize market confidence and expectations, promoting stable and healthy economic operation.
Interest rate cut refers to a reduction in either the benchmark deposit rate or the benchmark lending rate.
When interest rates decrease, investors earn less from their savings deposits, leading them to withdraw money for investment purposes, such as buying shares or houses.
Correspondingly, the borrowing costs for businesses and individuals also decrease, making more people willing to borrow and invest.
An interest rate cut does not increase the overall money supply in the market, but it can change the direction of funds. In other words, an interest rate cut encourages consumption and investment.
For example, let’s consider Jack, a prudent investor who typically invests his savings in bank wealth management products or fixed-term deposits. However, over the past two years, the central bank has consistently reduced interest rates, causing the annual interest rate on bank wealth management products to drop from 4.5% to 2.8%.
As returns on wealth management products decline, Jack finds himself reconsidering whether he needs to revise his investment strategy.
After a period of learning and consultation, Jack considers allocating a portion of his funds to higher-yielding and higher-risk funds and shares.
This case illustrates that an interest rate cut plays a guiding role in market direction and provides significant assistance in attracting long-term funds to the share market.
Both reserve requirement cuts and interest rate cuts are powerful tools used by the central bank to control the market and regulate market liquidity, exerting a strong influence on the market economy.
