Accumulated excess reserves

What Are Accumulated Excess Reserves?

Accumulated excess reserves refer to the funds that depository institutions hold at their central bank in excess of the reserve requirements mandated by regulatory authorities. These reserves are a crucial component of the financial system, particularly within the realm of central banking and monetary policy. While banks must hold a certain percentage of their deposits as required reserves, any additional funds parked at the central bank are considered excess reserves. Historically, banks minimized excess reserves because they did not earn interest; however, this changed in many jurisdictions, significantly impacting their accumulation.

History and Origin

The concept of excess reserves has always existed, but their accumulation became particularly significant following the 2008 financial crisis. Prior to this period, banks typically held very few excess reserves, preferring to lend out any funds beyond their requirements to generate income. However, legislative changes paved the way for a new era. The Financial Services Regulatory Relief Act of 2006 initially authorized Federal Reserve Banks to pay interest on reserve balances, with an effective date of October 1, 2011. This authority was accelerated to October 1, 2008, by the Emergency Economic Stabilization Act of 2008, a direct response to the unfolding crisis.⁸

The introduction of interest on reserves (IOR) by the Federal Reserve fundamentally altered the incentives for banks. By paying interest rates on both required and excess reserves, the Fed provided banks with a risk-free return on these holdings.⁷ This policy was designed to give the Federal Reserve greater control over the federal funds rate and to facilitate its expansive lending programs during the crisis, such as quantitative easing, without causing a sharp drop in short-term market rates.⁶ As the Fed significantly expanded its balance sheet through large-scale asset purchases, the volume of reserves in the banking system, and consequently accumulated excess reserves, swelled to unprecedented levels.

Key Takeaways

• Accumulated excess reserves are bank funds held at a central bank beyond the mandated requirements.
• The Federal Reserve began paying interest on these reserves in 2008, dramatically changing bank incentives.
• These reserves play a key role in the implementation of modern monetary policy, influencing short-term interest rates.
• A significant increase in accumulated excess reserves often results from central bank actions like quantitative easing.
• While providing liquidity and stability, high levels of accumulated excess reserves can also raise concerns about financial system efficiency and future inflation.

Formula and Calculation

Accumulated excess reserves are calculated by subtracting a bank's required reserves from its total reserves held at the central bank.

The formula is:

Where:

• Total Reserves represents the aggregate amount of funds a depository institution holds in its account at the central bank.
• Required Reserves are the minimum amount of funds a depository institution is legally obligated to hold, typically as a percentage of its deposits, as stipulated by the central bank.

Interpreting Accumulated Excess Reserves

The level of accumulated excess reserves held by depository institutions provides critical insights into the banking system's liquidity and the stance of monetary policy. A high volume of accumulated excess reserves, especially when the central bank pays interest on them, suggests that banks have ample funds beyond their immediate lending needs or regulatory obligations. This environment can indicate several things:

• Abundant Liquidity: Banks have significant buffers, which can enhance financial stability during periods of stress.
• Monetary Policy Stance: Large accumulated excess reserves are often a byproduct of expansionary monetary policies, such as quantitative easing, where the central bank injects massive amounts of liquidity into the financial system by purchasing Treasury securities and other assets.
• Interest Rate Control: In an "ample-reserve" framework, the central bank uses the interest rate paid on these reserves (IORB) as its primary tool to manage the federal funds rate. By adjusting the IORB, the central bank influences banks' incentives to lend or hold reserves, thereby guiding short-term market rates.

Conversely, a decline in accumulated excess reserves might signal a tightening of monetary policy or increased demand for private sector lending.

Hypothetical Example

Imagine "Diversification Bank" holds $500 million in customer deposits. If the central bank mandates a reserve requirement of 10%, Diversification Bank is required to hold $50 million (10% of $500 million) as required reserves at the central bank.

Now, let's say Diversification Bank actually holds $150 million in its account at the central bank.

To calculate its accumulated excess reserves:

• Total Reserves = $150 million
• Required Reserves = $50 million

Accumulated Excess Reserves = $150 million - $50 million = $100 million

In this scenario, Diversification Bank has $100 million in accumulated excess reserves. If the central bank is paying interest on these reserves, Diversification Bank earns income on this $100 million, influencing its decision-making regarding lending to other banks or extending credit to customers.

Practical Applications

Accumulated excess reserves are primarily observed and managed in the context of central banking and its implementation of monetary policy.

• Monetary Policy Implementation: Central banks, like the Federal Reserve, use accumulated excess reserves as a key lever to influence short-term interest rates. By adjusting the interest rate paid on these reserves, they can guide the effective federal funds rate. When banks have ample excess reserves, they have less incentive to lend to each other in the federal funds market, making the interest on reserves the de facto floor for overnight rates.⁵
• Liquidity Management: For individual depository institutions, managing their accumulated excess reserves is a critical part of liquidity management. Banks must balance earning income on these reserves with deploying funds for loans or investments.
• Quantitative Easing (QE) and Tightening (QT): Accumulated excess reserves often surge during periods of quantitative easing, where the central bank injects liquidity into the financial system by purchasing large volumes of government bonds and other assets through open market operations. Conversely, quantitative tightening aims to reduce these reserves as the central bank shrinks its balance sheet.⁴

Limitations and Criticisms

While the system of ample and accumulated excess reserves offers advantages in monetary policy implementation and financial stability, it also faces limitations and criticisms.

One concern is the potential for large accumulated excess reserves to create an "implicit subsidy" to banks, as they earn a risk-free return from the central bank on these balances.³ Critics argue that paying interest on excess reserves (IOER) may disincentivize banks from lending these funds into the real economy, potentially hindering economic activity. However, proponents counter that IOER allows the central bank to provide necessary liquidity during crises without losing control over interest rates.

Another critique revolves around the sheer size of central bank balance sheets, which are largely responsible for the high levels of accumulated excess reserves. This expansion, particularly during periods of quantitative easing, has led some to question the long-term implications for central bank independence and the potential for future inflation.² The increased reliance on interest on reserves to manage the federal funds rate has also altered traditional money markets, such as the interbank lending market, making them less active.¹

Accumulated Excess Reserves vs. Required Reserves

The distinction between accumulated excess reserves and required reserves is fundamental to understanding central bank policy and bank liquidity.

While required reserves represent a baseline for prudential banking and monetary control, accumulated excess reserves represent the dynamic surplus liquidity within the banking system. The shift to paying interest on all reserves, including excess, has blurred the operational distinction between the two for banks, as both now earn a return.

FAQs

Why do banks hold accumulated excess reserves?

Banks hold accumulated excess reserves primarily for two reasons: to earn interest payments from the central bank, providing a risk-free return on liquid assets, and to maintain sufficient liquidity for operational needs and unexpected outflows. This became particularly prevalent after the Federal Reserve began paying interest on excess reserves in 2008.

How do central bank actions affect accumulated excess reserves?

Central bank actions, especially large-scale asset purchases (e.g., quantitative easing), directly increase the level of accumulated excess reserves in the banking system. When a central bank buys assets from commercial banks, it credits their reserve accounts at the central bank, injecting new reserves into the system.

Do accumulated excess reserves lead to inflation?

The relationship between accumulated excess reserves and inflation is complex. While a large volume of reserves means more money in the banking system, it does not automatically translate into higher inflation unless those reserves are extensively lent out into the economy, increasing the money supply in circulation. The central bank's ability to pay interest on these reserves helps manage this risk by incentivizing banks to hold, rather than lend, these funds, thereby controlling their inflationary potential.

What is the difference between total reserves and accumulated excess reserves?

Total reserves refer to all funds a bank holds at the central bank. Accumulated excess reserves are the portion of these total reserves that exceeds the legally mandated reserve requirements. Therefore, total reserves include both required reserves and accumulated excess reserves.

Are accumulated excess reserves common in other countries?

Yes, many central banks globally, particularly after the 2008 financial crisis, adopted policies similar to the Federal Reserve's, including paying interest on reserves. This has led to accumulated excess reserves becoming a common feature in many developed economies' financial systems as central banks manage monetary policy in an ample-reserve environment.