1. Banks profit from the difference between the interest collected and the interest paid.
Example
Let’s assume that the mandatory reserve ratio = 10% of the total deposits
CIB Balance Sheet on December 21, 2022, in EGP
Assets
Central reserve without interest = 10
Loans with 12% interest = 100
Total assets = 110
Liabilities and Equity
Deposit with 10% interest = 100
Equity of shareholders = 10
Total liabilities and shareholders’ equity = 110
Income Statement in 2023
Total interest gained = 100 x 12% = 12
Paid interest = 100 x 10% = 10
Net profit = 2
Return on equity = 2/10 = 20%, which is the percentage targeted by the bank’s management.
What if the mandatory reserve ratio increased from 10% to 20% and the rate of return on the target equity did not change?
The bank can do 3 things:
1. Increase interest on loans
2. Reduces interest on deposits
3. 1 and 2 together
In this example, we will raise the interest to achieve a profit = of 2 or 20% on equity even after increasing the mandatory reserve ratio to 20%.
Earned interest – interest paid = 2
Earned interest = assets other than reserves x lending interest that has not yet been determined and we symbolize it with a question mark?.
Total interest = 110 – (deposit x mandatory reserve) x?
minus
Paid interest = 100 x 10% = 10
=
net profit equals 2
if
110 – (100 x 20%) x ? – 100 x 10% = 2
(110 – 20) x ? – 10 = 2
90 x ? = 12
? = 12/90 = 13.3%
So, in order for the link to maintain the same profit and the same return on equity, which is 20%, the interest on lending must be raised by about 1.3% from 12% to 13.3%.
Required Reserve
