Absolute excess reserves

What Is Absolute Excess Reserves?

Absolute excess reserves refer to the cash held by a financial institution at a central bank beyond the minimum amount required by regulatory authorities. These reserves represent funds that a bank has on deposit with its central bank that are not needed to meet its reserve requirement. The concept of absolute excess reserves is crucial within the realm of monetary policy, as the level of these reserves can influence a bank's lending capacity and the overall money supply in an economy. While a certain amount of reserves provides liquidity and safety, holding excessive amounts of absolute excess reserves can have implications for both bank profitability and the effectiveness of central bank actions.

History and Origin

The concept of bank reserves has existed for centuries, evolving from early banking practices to formal regulations. In the United States, reserve requirements have been a component of banking since the 1800s, with state laws introducing them after financial crises like the one in 1837. Historically, these requirements were primarily a tool for prudential banking regulation, ensuring banks maintained a buffer against withdrawals. For many years, banks aimed to hold just enough reserves to meet their requirements, minimizing "excess" as it represented an opportunity cost—funds that could otherwise be lent out for higher returns.

A significant shift occurred with the passage of the Financial Services Regulatory Relief Act of 2006, which authorized the Federal Reserve to pay interest rates on reserves. Although initially set to take effect in 2011, the Emergency Economic Stabilization Act of 2008 accelerated this, allowing the Fed to begin paying interest on both required and absolute excess reserves in October 2008, amidst the global financial crisis., ²³This marked a turning point, incentivizing banks to hold reserves at the central bank. The level of absolute excess reserves soared in the years following the 2008 crisis, largely due to the Federal Reserve's quantitative easing programs, which injected substantial liquidity into the banking system.

However, a pivotal change occurred more recently. Effective March 26, 2020, the Federal Reserve reduced reserve requirement ratios for all depository institutions to zero percent. This action essentially eliminated the concept of required reserves and, by extension, the formal calculation of absolute excess reserves based on a mandatory ratio.,
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21## Key Takeaways

• Absolute excess reserves were funds held by a bank at its central bank beyond legally mandated minimums.
• Historically, these reserves provided banks with additional liquidity and acted as a buffer against unexpected events.
• The Federal Reserve began paying interest on these reserves in 2008, influencing bank behavior.
• As of March 2020, the Federal Reserve eliminated reserve requirements, rendering the traditional definition of absolute excess reserves obsolete in the U.S. context.
• Despite the elimination of formal reserve requirements, banks still hold significant balances at the central bank, which continue to influence the financial system.

Formula and Calculation

Before March 2020, absolute excess reserves were calculated as the difference between a bank's total reserves held at the central bank and its required reserves.

The formula was:

$\text{Absolute Excess Reserves} = \text{Total Reserves Held} - \text{Required Reserves}$

Where:

• Total Reserves Held: The total amount of funds a bank holds in its account at the central bank plus any vault cash that counts towards its reserve obligations.
• Required Reserves: The minimum amount of reserves a bank was legally obligated to hold, determined by applying a reserve requirement ratio to certain types of deposits (known as reservable liabilities). This was specified under the Federal Reserve's Regulation D.

²⁰Since March 26, 2020, the reserve requirement ratio for all depository institutions in the U.S. has been reduced to zero percent., ¹⁹T¹⁸his means that, in the U.S., the concept of "required reserves" is now zero, and therefore, all reserves held by a bank at the Federal Reserve can be considered "excess" in the sense that they are not legally mandated. However, the formal "absolute excess reserves" as a calculable amount above a non-zero requirement no longer applies.

Interpreting Absolute Excess Reserves

In an environment where reserve requirements existed, a high level of absolute excess reserves indicated that banks had significant funds available beyond their regulatory obligations. This excess liquidity could suggest several things:

• Bank Prudence: Banks might choose to hold more reserves as a safety buffer for unforeseen loan losses or significant cash withdrawals.
  *¹⁷ Limited Lending Opportunities: If banks held substantial absolute excess reserves, it could imply a lack of profitable and safe lending opportunities in the economy.
• Monetary Policy Stance: High levels of absolute excess reserves, especially when the central bank pays interest on them, can be a sign of an accommodative monetary policy designed to inject liquidity into the financial system. The central bank can influence these levels by adjusting the interest rate paid on reserve balances.

¹⁶Conversely, very low absolute excess reserves could signal that banks were near their minimum reserve levels, potentially limiting their capacity for new lending if demand for credit supply were to increase suddenly.

Hypothetical Example

Consider a hypothetical scenario before March 2020, when reserve requirements were still in place.

Suppose "DiversiBank" had:

• Total Transaction Accounts (subject to reserve requirements): $1,000,000
• Reserve Requirement Ratio: 10% (for simplicity, assuming a flat rate)

In this case:
Required Reserves = $1,000,000 * 10% = $100,000

Now, if DiversiBank held $250,000 in its account at the central bank (its total reserves):

Absolute Excess Reserves = Total Reserves Held - Required Reserves
Absolute Excess Reserves = $250,000 - $100,000 = $150,000

This $150,000 represents the absolute excess reserves that DiversiBank held over and above what was legally mandated. DiversiBank could choose to hold these funds for additional liquidity or lend them out in the interbank market.

Practical Applications

Historically, absolute excess reserves had several practical applications in the financial system:

• Monetary Policy Tool: Central banks could influence the level of absolute excess reserves to manage the federal funds rate and overall economic activity. By paying interest on these reserves, central banks could set a floor for the interbank lending rate, as banks would not lend to other institutions at a rate lower than what they could earn risk-free from the central bank.
  *¹⁵ Liquidity Management: Banks often held absolute excess reserves as a buffer for daily operations, including clearing payments and managing unexpected cash flows. This extra liquidity could help prevent short-term funding crises.
• Financial Stability: During periods of financial stress, a high level of absolute excess reserves could contribute to financial stability by providing banks with ample funds to meet obligations without resorting to emergency borrowing from the central bank's discount window.
• Quantitative Easing Effectiveness: Large-scale asset purchases, or quantitative easing (QE), conducted by central banks often led to a significant increase in absolute excess reserves as the central bank purchased assets from commercial banks. This influx of reserves aimed to lower long-term interest rates and stimulate lending.

The Federal Reserve's move to zero percent reserve requirements in 2020 means that reserves are now primarily used to manage the federal funds rate through administered rates, such as the interest on reserve balances (IORB) and the overnight reverse repurchase agreement (ON RRP) facility., ¹⁴T¹³he focus has shifted from managing a specific level of "excess" reserves to operating in an "ample reserves" regime, where the quantity of reserves is sufficiently large to ensure control over the federal funds rate and maintain financial stability. For more detailed information on reserve requirements, the Federal Reserve Board provides resources on its monetary policy tools.

¹²## Limitations and Criticisms

The concept and management of absolute excess reserves, particularly when they were abundant, faced certain limitations and criticisms:

• Opportunity Cost: For banks, holding large amounts of absolute excess reserves meant that these funds were not being deployed into higher-yielding assets like loans or investments, potentially impacting their balance sheet and profitability. W¹¹hile central banks pay interest on reserves, this rate is typically lower than what could be earned through market lending.
  *¹⁰ Impact on Monetary Policy Transmission: Some economists argued that high levels of absolute excess reserves could complicate the transmission of monetary policy. In such an environment, banks might be less responsive to changes in benchmark interest rates if they prefer to hold onto their ample reserves rather than lend them out. R⁹esearch, such as that concerning the European Central Bank's rate hiking cycle, suggests that large excess reserves can affect monetary policy transmission.
  *⁸ Inflationary Concerns: While the payment of interest on excess reserves was intended to help control inflation by preventing banks from lending out all their excess funds, some critics raised concerns that a large pool of absolute excess reserves could pose a potential inflationary risk if banks were to rapidly convert them into loans and deposits.
  *⁷ Shift in Central Bank Operations: The massive increase in absolute excess reserves, especially after the 2008 financial crisis, represented a significant departure from the Federal Reserve's historical operating framework. This shift to an "ample reserves" regime required new strategies for implementing monetary policy.

⁶## Absolute Excess Reserves vs. Required Reserves

The distinction between absolute excess reserves and required reserves is fundamental to understanding historical banking regulations and central bank operations.

Before 2020, confusion often arose because both terms related to reserves held by banks at the central bank. However, required reserves were the baseline, a regulatory obligation, while absolute excess reserves represented the amount freely held beyond that baseline. With the elimination of reserve requirements in the U.S., all reserves held by banks at the Federal Reserve are technically "excess" relative to a zero requirement, though the operational framework for monetary policy has evolved to an "ample reserves" regime where the payment of interest on reserve balances (IORB) is key.

FAQs

What happened to absolute excess reserves after 2020?

In March 2020, the Federal Reserve reduced reserve requirement ratios for all depository institutions to zero percent., ⁴T³his means that, in the U.S., there are no longer any mandated required reserves. As a result, the traditional calculation of absolute excess reserves, which was the amount held above a non-zero requirement, is no longer applicable. Banks still hold substantial balances at the Federal Reserve, which are now all considered "excess" in the absence of a reserve requirement. The Federal Reserve continues to pay interest on these balances through the Interest on Reserve Balances (IORB) rate.

²### Do banks still benefit from holding reserves at the Federal Reserve?

Yes, banks still benefit from holding balances at the Federal Reserve, even without formal reserve requirements. The Federal Reserve pays interest on these reserve balances (IORB), providing banks with a risk-free return. T¹hese balances also serve as a crucial source of liquidity for interbank transactions, payments, and as a buffer against unforeseen funding needs.

How do central banks influence bank lending now that reserve requirements are zero?

With reserve requirements at zero, central banks primarily influence bank lending and the economy through other monetary policy tools. The key tool in an "ample reserves" regime is the interest rate paid on reserve balances (IORB). By adjusting this rate, the central bank influences the cost of funds for banks and sets a floor for short-term market interest rates. Other tools include open market operations and the discount window.