Active excess reserves: Meaning, Criticisms & Real-World Uses

What Is Active Excess Reserves?

Active excess reserves refer to the funds that depository institutions hold at their nation's central bank in excess of any required amounts. In the context of central banking and monetary policy, these reserves represent the liquid capital available to banks beyond what is mandated by regulatory bodies or deemed necessary for day-to-day operations. Historically, bank reserves were divided into required reserves—the minimum amount banks had to hold—and excess reserves. However, since March 26, 2020, the Federal Reserve eliminated reserve requirements for all depository institutions in the United States, meaning that all reserves held at the Federal Reserve are now, by definition, considered excess reserves. Th²¹erefore, "active excess reserves" in the current environment largely refers to the substantial balances banks maintain at the central bank, which play a crucial role in the financial system's liquidity and the transmission of monetary policy.

History and Origin

The concept of bank reserves dates back to the early days of banking, designed to ensure that banks held sufficient cash to meet depositor withdrawals and maintain financial stability. In the United States, formalized reserve requirements were put in place with the establishment of the Federal Reserve System in 1913, following a series of financial panics. For decades, the Federal Reserve utilized changes in the required reserves ratio as a tool to influence the money supply and lending activity.

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 held by banks. This authority was later accelerated by the Emergency Economic Stabilization Act of 2008, allowing the Fed to begin paying interest on both required and excess reserves starting October 1, 2008. Th¹⁷, ¹⁸, ¹⁹, ²⁰is change was particularly impactful during the 2008 financial crisis, as it provided the Federal Reserve with a new mechanism to influence the federal funds rate and manage the large increase in bank reserves resulting from its quantitative easing programs. Pr¹⁵, ¹⁶ior to this, banks had little incentive to hold excess reserves because these funds earned no return. The ability to pay interest on these balances fundamentally changed banks' incentives and the landscape of monetary policy implementation. The ultimate elimination of reserve requirements in 2020 further solidified the role of active excess reserves, as these are now the primary form of reserves held by banks at the Federal Reserve.

##¹⁴ Key Takeaways

Active excess reserves represent the funds banks hold at the central bank beyond what is legally or operationally required.
Since March 2020, all reserves held by U.S. banks at the Federal Reserve are classified as excess reserves due to the elimination of reserve requirements.
The Federal Reserve pays interest on these reserves, influencing banks' lending decisions and the broader financial system.
They serve as a significant component of banks' liquidity buffers and play a crucial role in the central bank's control over short-term interest rates.
High levels of active excess reserves can impact the effectiveness of monetary policy transmission and may present potential inflationary risks if not managed appropriately.

Formula and Calculation

Historically, excess reserves were calculated as the difference between a bank's total reserves and its required reserves.

\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}

In this formula:

(\text{Total Reserves}) represents the sum of a bank's vault cash and its deposits held at the central bank.
(\text{Required Reserves}) refers to the minimum amount of reserves that a bank was mandated to hold by regulation, typically a percentage of its eligible deposits.

However, given the Federal Reserve's decision to set the reserve requirement ratio to zero percent for all depository institutions as of March 26, 2020, the calculation has effectively simplified. In the U.S. context, since there are no longer any statutory required reserves, a bank's "active excess reserves" are now synonymous with its "total reserves" held at the Federal Reserve.

\text{Active Excess Reserves} = \text{Total Reserves Held at Federal Reserve}

This means that any funds a bank holds at the Federal Reserve Bank are now considered active excess reserves.

Interpreting the Active Excess Reserves

The level of active excess reserves in the banking system provides key insights into the financial system's liquidity and the stance of monetary policy. A high level of active excess reserves typically indicates that banks have ample funds beyond their immediate operational needs. Before 2008, significant excess reserves were rare because they earned no interest and represented an opportunity cost; banks preferred to lend out available funds to maximize returns.

T¹³he introduction of interest on reserves (IORB) by the Federal Reserve changed this dynamic. By adjusting the interest rate paid on these balances, the Federal Reserve can influence the incentives for banks to lend or hold reserves, thereby impacting the federal funds rate and broader interest rates in the economy. Wh¹²en the central bank raises the IORB rate, it makes holding reserves more attractive, potentially reducing bank lending and tightening financial conditions. Conversely, lowering the IORB rate can encourage banks to lend more, stimulating economic growth.

Hypothetical Example

Consider a commercial bank, "First National Bank," operating in a country where the central bank has eliminated reserve requirements, similar to the current U.S. system. First National Bank receives a large deposit of $100 million from a corporate client. Historically, a portion of this deposit would have been set aside as required reserves. However, with no reserve requirement, the entire $100 million deposited at the central bank by First National Bank immediately becomes part of its active excess reserves.

If the central bank is paying 2.5% interest rates on these reserves, First National Bank will earn 2.5% on the $100 million it holds at the central bank. The bank's management must then decide whether to keep these funds as active excess reserves, earning a risk-free return, or to deploy them through lending to customers or investing in securities, which might offer higher potential returns but also carry more risk. The higher the interest paid on these reserves, the greater the incentive for First National Bank to hold onto them rather than converting them into loans or other assets.

Practical Applications

Active excess reserves are a cornerstone of modern monetary policy implementation, particularly in economies with a floor-system operational framework (where the central bank aims to keep the policy rate at or above the interest paid on reserves).

Interest on Reserve Balances (IORB) as a Policy Tool: The Federal Reserve uses the Interest on Reserve Balances (IORB) rate to steer the federal funds rate within its target range. By¹⁰, ¹¹ adjusting the IORB rate, the Federal Reserve can influence the incentives for banks to borrow or lend reserves in the federal funds market. A higher IORB rate encourages banks to hold reserves at the Fed, providing a floor for overnight interest rates.
Liquidity Management: For individual banks, holding active excess reserves provides a significant liquidity buffer. Th⁹ese funds can be readily accessed to meet unexpected withdrawals, clear payments, or settle interbank transactions, reducing the risk of a liquidity crisis.
Quantitative Easing and Tightening: During periods of quantitative easing (QE), the central bank purchases assets, injecting large amounts of reserves into the banking system, which accumulate as active excess reserves on banks' balance sheet. Co⁸nversely, during quantitative tightening (QT), the central bank reduces its asset holdings, draining reserves from the system and reducing active excess reserves.
⁷ Financial Stability: Maintaining healthy levels of active excess reserves contributes to overall financial stability by providing banks with a cushion against unforeseen financial shocks and reducing reliance on volatile short-term funding markets. An⁶ ample supply of reserves ensures that the banking system can continue to function smoothly even during times of stress. The Federal Reserve Bank of San Francisco, in an economic letter, discussed how strong fiscal responses led to unprecedented levels of household savings, implying these could support spending if drawn down, demonstrating the broad impact of liquidity in the system.

#⁵# Limitations and Criticisms

While active excess reserves are a vital component of the modern financial system and monetary policy, they are not without limitations or criticisms.

One concern revolves around the potential for inflationary pressures. Historically, large quantities of excess reserves were seen as a "tinder" for future inflation if banks were to rapidly increase lending. Ho⁴wever, the current framework, where the Federal Reserve pays interest on these reserves, allows the central bank to control the incentive for banks to lend, thus mitigating this risk. The ability to raise the interest rate on excess reserves enables the Fed to manage inflationary increases in loans and deposits, even with a high level of reserves.

A³nother criticism relates to the impact on the monetary policy transmission mechanism. With abundant active excess reserves, the traditional channel of monetary policy, which relied on managing the scarcity of reserves, changes significantly. The central bank must now rely more heavily on the interest rate it pays on reserves to influence other market interest rates. So²me economists argue that this shift makes it harder for the central bank to receive its "usual signals" from the banking system about the pace of monetary expansion, potentially causing policy to fall behind economic developments. Fu¹rthermore, there's an ongoing debate regarding the optimal level of reserves and whether persistently high levels could lead to a less efficient allocation of capital if banks choose to hold reserves for a guaranteed, risk-free return rather than engaging in productive lending.

Active Excess Reserves vs. Required Reserves

The distinction between active excess reserves and required reserves has evolved significantly in U.S. banking.

Feature	Required Reserves	Active Excess Reserves (Pre-2020)	Active Excess Reserves (Post-2020 U.S.)
Definition	The minimum amount of funds a bank must hold, stipulated by the central bank.	Funds held by a bank above its required reserve level.	All reserves held by a bank at the Federal Reserve, as requirements are zero.
Purpose	Historically, to ensure banks maintain sufficient liquidity and stabilize the banking system.	Additional liquidity buffer, or available for lending or investment.	Primary pool of bank reserves influencing money markets and monetary policy.
Interest Paid	Historically, no interest was paid. Interest on required reserves began in 2008.	Historically, no interest was paid. Interest on excess reserves began in 2008.	Interest is paid on these balances by the Federal Reserve.
Current Status	Reserve requirements for U.S. depository institutions were eliminated in March 2020.	Conceptually merged with "total reserves" as there are no longer required reserves.	All reserves are now effectively "excess."

Before March 2020, required reserves were a specific, mandated percentage of a bank's deposits, held either as vault cash or deposits at the Federal Reserve. Active excess reserves, at that time, were any balances held above this regulatory minimum. The confusion often arose because both contributed to a bank's total reserves, but only the excess portion was readily available for new lending or investment without violating regulations. With the elimination of reserve requirements, the operational distinction has largely disappeared in the U.S., simplifying the understanding that any reserves a bank holds at the Federal Reserve are now considered active excess reserves, available for its use or subject to the central bank's interest payments.

FAQs

Why are active excess reserves important now that reserve requirements are zero?

Even with zero reserve requirements, active excess reserves remain crucial because the Federal Reserve pays interest on them. This interest rate, known as the Interest on Reserve Balances (IORB) rate, is a primary tool the Fed uses to manage short-term interest rates and influence overall monetary policy and economic growth. Banks still hold reserves for operational needs, such as settling payments.

Do active excess reserves contribute to inflation?

While large active excess reserves might theoretically enable more bank lending and money creation, the Federal Reserve's ability to pay interest on these reserves helps to manage potential inflationary pressures. By adjusting the interest rate paid, the Fed can influence banks' incentives to hold reserves versus lending them out, thereby controlling the money supply.

How do banks use their active excess reserves?

Banks use active excess reserves primarily for liquidity management, to settle transactions with other banks, and to meet unexpected withdrawals. They also hold these reserves to earn interest paid by the Federal Reserve, providing a risk-free return on these balances.

What is the difference between active excess reserves and free reserves?

The term "free reserves" generally refers to a bank's total excess reserves minus any borrowings from the central bank's discount window. It indicates the amount of reserves that are truly "free" from obligations or costs, allowing a more precise measure of a bank's discretionary liquidity. Active excess reserves, in the current context, broadly refers to all reserves held beyond a zero requirement, and may or may not include funds borrowed from the discount window if they are still held at the Fed.