Understanding Excess Reserves
Excess reserves are capital reserves held by a bank or financial institution that exceed the amount mandated by regulatory authorities, creditors, or internal controls. For commercial banks, these excess amounts are measured against standard reserve requirement ratios set by central banking authorities. These ratios dictate minimum liquid deposits (like cash) that must be available as reserves at a bank; anything above this requirement is considered excess.
Excess reserves are also referred to as secondary reserves, distinguishing them from free reserve money. Unlike free reserves—which deduct amounts borrowed from the Fed’s discount window—excess reserves represent funds exceeding regulatory requirements retained voluntarily.
Key Takeaways
- Safety Net: Excess reserves serve as a buffer, providing banks with extra safety against sudden loan losses or substantial cash withdrawals by customers.
- Policy Shift: The Federal Reserve discontinued traditional reserve requirements in 2020, thus redefining the concept of excess reserves under its revamped monetary policies.
- Profit Incentive: Banks can earn interest on voluntarily-held reserves via the Interest on Reserve Balances (IORB) program.
The Purpose and Utilization of Excess Reserves
Reserves are designed as a safety buffer for banks to address unanticipated needs for additional capital in their daily operations. The advent of interest on excess reserves incentivizes banks to maintain funds exceeding regulatory requirements. By holding excess reserves, financial institutions preserve an extra layer of security to weather unexpected economic shocks.
A Historical Perspective on U.S. Excess Reserves
Reserves have embedded themselves into the U.S. banking system since the 1800s, evolving to tackle various economic crises over time. Post the real estate bubble collapse and banking failures of 1837, state laws mandated reserve requirements which evolved into federal regulations.
With the Financial Services Regulatory Relief Act of 2006, the Federal Reserve gained authorization to pay interest on reserves, incentivizing banks to hold reserves with the central bank. The practical implementation was accelerated by the Emergency Economic Stabilization Act of 2008 during the Great Recession.
Excess reserves reached unprecedented levels during this period, peaking at $2.7 trillion in August 2014 as a result of quantitative easing (QE). By early 2020, these balances varied between $1.3 trillion and $1.6 trillion. The COVID-19 pandemic further spiked these numbers, reflecting continued reliance on central support.
Federal Reserve Bank of St. Louis
In a 2020 shift, the Federal Reserve eliminated mandatory reserve requirements, implementing a voluntary program where reserves maintained still accrued interest—a move establishing an effective floor for interbank overnight rates.
Factors Influencing Excess Reserve Balances
Several factors dictate the level of excess reserves banks choose to maintain:
- Interest Incentive: Via the Interest on Excess Reserves (IOER), banks earn interest on their reserves, making it appealing to keep funds untouched.
- Quantitative Easing Impact: Monetary inflows into reserve accounts significantly inflate reserve balances. Banks, in response, opting to retain such funds as a financial buffer.
- Operational Needs: Banks need to balance reserves to maintain liquidity and manage anticipated transactions, hence the higher reserves in alignment with profit strategy.
Differentiating Excess Reserves and Required Reserves
- Required Reserves: The mandated amount of capital banks must hold as reserves, determined by central bank liquidity requirements.
- Excess Reserves: Any reserve capital held above the stipulated required reserve.
Considerations for Holding Excess Reserves
Banks juggle between holding excess reserves—which provide liquidity and security—and utilizing that capital for lending opportunities to generate interest income. A pivotal decision influenced by central bank policies and economic climates.
Are Excess Reserves Financial Liabilities?
Reserves, especially when interest-bearing, become liabilities for central banks as they represent obligations for interest payments.
The Final Word on Excess Reserves
Excess reserves represent the surplus capital held by banks beyond defined requirements, aimed at providing financial stability and interest gains. Despite the Federal Reserve’s discontinuation of mandatory reserve requirements in 2020, the practice of holding excess reserves remains prevalent and is critical in different economic systems worldwide, highlighted by guidelines from the International Monetary Fund for central bank operations.
Related Terms: Free reserves, Required reserves, Interest on Reserve Balances, Quantitative easing, Reserve requirements.
References
- International Journal of Central Banking. “Lessons from the Historical Use of Reserve Requirements in the United States to Promote Bank Liquidity”.
- Federal Reserve Board. “Interest on Reserve Balances”.
- U.S. Federal Reserve System. “The Fed Explained: What the Central Bank Does”, Page 40.
- Federal Reserve Bank of St. Louis. “Interest Rate on Excess Reserves (Discontinued)”.
- U.S. Federal Reserve System. “The Fed Explained: What the Central Bank Does”, Page 35.
- Federal Reserve Bank of Cleveland. “Excess Reserves: Oceans of Cash”.
- International Monetary Fund. “Monetary Operations and Domestic Market Development: Reserve Requirements”.
