Aggregate excess reserves

What Is Aggregate Excess Reserves?

Aggregate excess reserves refer to the total amount of funds that all commercial banks in a financial system collectively hold at their central bank above and beyond what is legally or prudentially required. This concept falls under the broader financial category of monetary policy and central banking, as it directly relates to how a central bank influences the money supply and overall liquidity in the economy. While individual commercial banks manage their own reserve levels, aggregate excess reserves provide a system-wide view of the banking sector's reserve position.

Historically, central banks set a reserve requirement, which mandated a minimum percentage of certain deposits that banks must hold as reserves. Any reserves held above this minimum were considered excess. In the United States, for instance, the Federal Reserve maintained reserve requirements until March 2020, when it reduced them to zero. Despite this change, the concept of excess reserves remains relevant for understanding historical monetary policy actions and for financial systems in other countries where reserve requirements may still be in place. Even without formal requirements, banks can voluntarily hold reserves at the central bank, often earning interest, influencing their balance sheets and lending decisions.

History and Origin

The concept of bank reserves has been a part of banking systems for centuries, evolving with the development of central banking. In the U.S., state laws began requiring reserves in the 1800s, with these requirements changing over time to adapt to economic circumstances. However, large aggregate excess reserves became a prominent feature of the Ues, particularly after the 2008 financial crisis. Prior to this period, excess reserves in the U.S. banking system were typically very low, often near zero.²¹

A significant turning point occurred with the passage of the Financial Services Regulatory Relief Act of 2006, which granted the Federal Reserve authority to pay interest on reserves.²⁰ This authority was accelerated by the Emergency Economic Stabilization Act of 2008, allowing the Federal Reserve to begin paying Interest on Excess Reserves (IOER) starting October 1, 2008.¹⁹,¹⁸,¹⁷ This policy change was intended to help the Fed manage the federal funds rate more effectively and provide liquidity during the financial crisis.¹⁶,¹⁵ As the Federal Reserve engaged in large-scale asset purchases, known as quantitative easing, bank reserves surged dramatically, leading to unprecedented levels of aggregate excess reserves.¹⁴

Key Takeaways

• Aggregate excess reserves represent the total reserves held by banks above regulatory or prudential requirements within a financial system.
• Historically, these reserves were minimal in the U.S. until the 2008 financial crisis and the introduction of interest payments on reserves.
• High levels of aggregate excess reserves can influence monetary policy transmission, potentially affecting lending and inflation.
• While the U.S. Federal Reserve reduced reserve requirements to zero in 2020, the concept remains relevant for understanding historical policy and for other central banking systems globally.
• Central banks can use the rate paid on excess reserves as a tool to influence market interest rates and the overall money supply.

Formula and Calculation

The calculation for aggregate excess reserves is straightforward: it is the difference between total reserves held by all banks and the total required reserves.

Where:

• Total Reserves: The sum of all reserves held by all commercial banks at the central bank. This includes vault cash and balances held directly at the central bank.
• Total Required Reserves: The sum of reserves that all banks are mandated to hold based on the prevailing reserve requirement ratio applied to their eligible deposits.

For example, if the total reserves in a banking system are \($5) trillion and the total required reserves are \($500) billion, the aggregate excess reserves would be \($4.5) trillion. In jurisdictions like the U.S. where reserve requirements are currently zero, the entire amount of reserves held by banks at the Federal Reserve effectively functions as excess reserves.

Interpreting the Aggregate Excess Reserves

The level of aggregate excess reserves provides insights into the liquidity within the banking system and the stance of monetary policy. A large volume of aggregate excess reserves typically suggests that banks have ample funds beyond their immediate operational needs and regulatory mandates. Before central banks began paying Interest on Excess Reserves (IOER), a high level of excess reserves might have indicated weak loan demand or an abundance of liquidity in the system, as banks had little incentive to hold non-interest-bearing reserves.

However, in a regime where interest is paid on reserves, the interpretation changes. Banks may choose to hold significant aggregate excess reserves to earn a risk-free return, especially if that return is competitive with other low-risk investments or if there is uncertainty in the lending environment. This can sometimes reduce the incentive for banks to lend out these funds, affecting credit availability and broader economic growth.

Hypothetical Example

Consider a hypothetical country, "Diversifica," whose central bank still maintains a reserve requirement of 10% for all eligible deposits. The banking system in Diversifica has the following aggregate figures:

1. Total Eligible Deposits: \($10) trillion
2. Total Reserves held by commercial banks at the central bank: \($1.5) trillion

To calculate the aggregate excess reserves:

• Step 1: Calculate Total Required Reserves.
  Total Required Reserves = Total Eligible Deposits \(\times) Reserve Requirement Ratio
  Total Required Reserves = \($10) trillion \(\times) \(0.10) = \($1) trillion

• Step 2: Calculate Aggregate Excess Reserves.
  Aggregate Excess Reserves = Total Reserves - Total Required Reserves
  Aggregate Excess Reserves = \($1.5) trillion - \($1) trillion = \($0.5) trillion

In this scenario, Diversifica's banking system holds \($500) billion in aggregate excess reserves. This indicates that banks collectively have \($500) billion more in reserves than they are legally mandated to hold, offering a substantial buffer for liquidity and potential for further lending if profitable opportunities arise and other factors encourage it.

Practical Applications

Aggregate excess reserves are a crucial indicator for central bankers and financial analysts, especially in jurisdictions where reserve requirements are maintained or where central banks actively use interest on reserves as a policy tool.

• Monetary Policy Implementation: Central banks can influence the level of aggregate excess reserves through open market operations, such as asset purchases or sales, and by adjusting the Interest on Excess Reserves (IOER) rate. A higher IOER rate can incentivize commercial banks to hold more reserves, potentially withdrawing money supply from circulation and tightening monetary conditions. Conversely, a lower IOER rate might encourage banks to lend more.¹³,¹²
• Liquidity Management: High aggregate excess reserves provide a significant liquidity buffer for the banking system, reducing the risk of sudden liquidity shortages and enhancing financial stability. Banks with ample excess reserves are better positioned to meet unexpected withdrawals or increased loan demand.
• Impact on Interbank Markets: The level of aggregate excess reserves can affect the federal funds rate and other short-term interbank interest rates. When aggregate excess reserves are abundant, banks may have less need to borrow from each other in the interbank market, putting downward pressure on these rates. The Federal Reserve, by paying interest on these balances, can establish a floor for the federal funds rate, influencing overall market rates.¹¹

For up-to-date data on aggregate reserves and related monetary components, the Federal Reserve provides detailed statistical releases, such as the H.3 series.¹⁰

Limitations and Criticisms

While aggregate excess reserves can serve as a substantial liquidity buffer, their accumulation, particularly in recent decades, has raised several considerations and criticisms. One common concern is the potential for inflationary pressures. Some economists have argued that a large quantity of aggregate excess reserves held by banks could lead to rapid credit expansion and higher inflation if banks decide to lend out these funds aggressively.⁹,⁸ However, others contend that in a system where interest is paid on reserves, the central bank can control this risk by adjusting the Interest on Excess Reserves (IOER) rate.,⁷

Another criticism revolves around the opportunity cost of holding these reserves. For banks, holding large amounts of aggregate excess reserves, even if remunerated, means that these funds are not being deployed into potentially higher-yielding investments or loans to businesses and households. This could theoretically dampen economic growth. However, research from various Federal Reserve Banks suggests that the relationship between excess reserves and bank lending is not always straightforward, particularly in environments where interest is paid on reserves and reserve requirements are not binding.⁶,⁵ The Federal Reserve Bank of Minneapolis, for example, has discussed the potential for banks to suddenly increase liquidity, which could cause inflation, but also acknowledges the Fed's tools to manage this risk.⁴

Additionally, high levels of aggregate excess reserves can complicate the transmission mechanism of monetary policy. In a system with abundant reserves, the link between the quantity of reserves and banks' willingness to lend may be weakened, requiring the central bank to rely more heavily on interest rates paid on reserves to guide market rates.,³ This can alter how monetary policy impacts the broader economy.

Aggregate Excess Reserves vs. Required Reserves

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

• Required Reserves: These are the minimum amounts of funds that commercial banks are legally mandated to hold in reserve, either as vault cash or as deposits at the central bank. This minimum is typically set as a percentage of the bank's eligible deposits, determined by the central bank's reserve requirement ratio. The purpose of required reserves is primarily to enable the central bank to manage the money supply and implement monetary policy, though they also serve as a basic prudential measure for bank liquidity.,,²
• Aggregate Excess Reserves: As discussed, these represent the total amount of reserves held by the entire banking system that exceed the sum of all required reserves. While required reserves are a non-discretionary obligation for banks (where such requirements exist), aggregate excess reserves are voluntarily held by banks. Banks might choose to hold excess reserves for various reasons, including prudential liquidity management, earning interest on reserves, or a lack of profitable lending opportunities.,¹

In essence, required reserves define the floor for bank reserve holdings, while aggregate excess reserves represent the buffer above that floor, reflecting the banking system's overall liquidity and often influenced by the central bank's administered rates, such as Interest on Excess Reserves (IOER).

FAQs

What causes aggregate excess reserves to increase?

Aggregate excess reserves typically increase when a central bank implements expansionary monetary policy, such as quantitative easing (large-scale asset purchases), which injects new reserves into the banking system. They can also rise if banks become more risk-averse and prefer to hold safe, liquid reserves over making new lending, or if there's a significant inflow of capital into the financial system.

Do banks earn interest on aggregate excess reserves?

In many modern financial systems, including the United States since 2008, central banks pay Interest on Excess Reserves (IOER). This provides banks with an incentive to hold reserves at the central bank, rather than exclusively seeking out lending opportunities, and gives the central bank a powerful tool to manage short-term interest rates.

Are aggregate excess reserves always a sign of weak lending?

Not necessarily. While a surge in aggregate excess reserves sometimes coincides with weak lending demand or bank deleveraging (as seen during the 2008 financial crisis), it can also be a deliberate outcome of a central bank's monetary policy designed to infuse liquidity into the system and influence the federal funds rate via interest payments on reserves. Banks may choose to hold these reserves for various reasons, even when lending opportunities exist.