What Is Excess Reserves?
Excess reserves are the funds held by depository institutions at a central bank in excess of what is legally required or prudentially desired. These reserves are a crucial component of monetary policy, representing the extra liquidity that banks possess beyond their mandated reserve requirements. While banks are generally incentivized to lend out available funds to earn an interest rate, holding excess reserves can be strategic, especially during periods of economic uncertainty or when central banks pay interest on these holdings.
History and Origin
Historically, banks held minimal excess reserves because they did not earn interest on these balances, and holding them meant forgoing potential earnings from lending or investments. This dynamic changed significantly following the 2007–2009 financial crisis. In the United States, the Federal Reserve gained authority from Congress through the Emergency Economic Stabilization Act of 2008 to pay interest on both required and excess reserves, accelerating a provision from the Financial Services Regulatory Relief Act of 2006 that was initially set for 2011. T11, 12his policy, known as Interest on Reserve Balances (IORB), transformed the role of excess reserves in monetary policy, allowing the Fed to manage short-term interest rates more effectively even with a large supply of reserves in the banking system. T9, 10he International Monetary Fund noted the significant expansion of central bank balance sheets and the resultant increase in bank reserves during this period, highlighting a new era of monetary policy where excess reserves became abundant.
8## Key Takeaways
- Excess reserves are bank funds held at a central bank beyond legal requirements.
- Central banks often use interest on excess reserves as a monetary policy tool to influence market interest rates.
- High levels of excess reserves can result from quantitative easing programs, where central banks inject large amounts of liquidity into the financial system.
- The management of excess reserves impacts bank lending behavior and the overall money supply.
- Understanding excess reserves is vital for analyzing central bank operations and their effects on the economy.
Formula and Calculation
Excess reserves are calculated as the difference between a bank's total reserves and its required reserves.
Where:
- Total Reserves: The total amount of funds a bank holds with the central bank, plus vault cash.
- Required Reserves: The minimum amount of reserves a bank is mandated to hold, typically a percentage of its deposits as set by the central bank.
For example, if a bank has $100 million in total reserves and its required reserves are $10 million, its excess reserves would be $90 million.
Interpreting the Excess Reserves
The level of excess reserves in the banking system offers insights into the prevailing economic and monetary conditions. A high level of excess reserves typically indicates that banks have ample liquidity. This can be a result of expansionary monetary policy, such as quantitative easing, where the central bank injects money into the system by purchasing assets. When excess reserves are high and central banks pay interest on them, banks might choose to hold these funds rather than lend them out, especially if lending opportunities are scarce or risky. This can influence the effective federal funds rate and other short-term market rates, as banks have less incentive to lend to each other at rates below what they can earn from the central bank.
Consider "Horizon Bank," which has $500 million in eligible deposits. The central bank sets a reserve requirement of 10%. This means Horizon Bank is required to hold $50 million in reserves (10% of $500 million).
Scenario 1: Horizon Bank holds $75 million in total reserves with the central bank.
- Required Reserves = $50 million
- Total Reserves = $75 million
- Excess Reserves = $75 million - $50 million = $25 million
In this scenario, Horizon Bank has $25 million in excess reserves, which it could potentially use for lending or investment, or hold at the central bank if it earns interest.
Scenario 2: The central bank initiates a quantitative easing program and purchases bonds from Horizon Bank, crediting its reserve account with an additional $200 million.
- New Total Reserves = $75 million + $200 million = $275 million
- Required Reserves (unchanged by QE directly) = $50 million
- New Excess Reserves = $275 million - $50 million = $225 million
Horizon Bank now has significantly higher excess reserves, increasing the overall liquidity in the banking system.
Practical Applications
Excess reserves are central to how modern central banks conduct monetary policy. By adjusting the interest rate paid on these reserves, central banks can influence the short-term interbank lending rates, such as the federal funds rate in the U.S. I5f the central bank raises the interest rate paid on excess reserves, banks are incentivized to hold more reserves rather than lend them, which can reduce lending and slow economic growth. Conversely, lowering this rate can encourage banks to lend more. This tool became particularly important after the 2008 financial crisis when central banks expanded their balance sheets through large-scale asset purchases (quantitative easing), leading to a surplus of reserves in the banking system. T4he European Central Bank, for instance, has actively managed excess liquidity through its refinancing operations and by adjusting the remuneration on excess reserves.
3## Limitations and Criticisms
While excess reserves are a vital tool in modern monetary policy, their management has faced certain criticisms. One concern raised by the Cato Institute is that paying interest on excess reserves might facilitate central bank interventions beyond their traditional functions, potentially distorting credit markets and making it harder to gauge the appropriate level of monetary accommodation. A2dditionally, high levels of excess reserves, particularly those stemming from unconventional policies like quantitative easing, can decouple the relationship between the monetary base and prices, making it challenging for central banks to control inflation using traditional methods. S1ome argue that maintaining a large quantity of excess reserves, even with interest payments, might disincentivize banks from extending credit to the real economy if the risk-adjusted returns on lending are lower than the interest earned on reserves. However, others contend that this provides a stable floor for interest rates and enhanced financial stability.
Excess Reserves vs. Required Reserves
The terms "excess reserves" and "required reserves" both refer to funds held by depository institutions at a central bank, but they represent distinct components of a bank's overall reserve holdings.
- Required Reserves: These are the minimum amount of funds that a central bank mandates commercial banks to hold, typically as a percentage of their eligible deposits. These requirements are in place to ensure banks have sufficient liquidity to meet withdrawal demands and to serve as a tool for monetary policy. Under a system of fractional-reserve banking, only a fraction of deposits are held as required reserves, with the rest available for lending.
- Excess Reserves: In contrast, excess reserves are any funds held by banks over and above these legally mandated required reserves. Historically, banks avoided holding excess reserves due to the opportunity cost, but with central banks now paying interest rate on these holdings, the incentive structure has changed. Excess reserves provide banks with additional financial flexibility and serve as a key channel through which central banks can implement monetary policy, especially in an environment of abundant reserves.
The confusion between the two often arises because both are components of a bank's total reserves. However, one is a regulatory minimum, while the other is an amount held voluntarily or as a result of central bank actions (like open market operations).
FAQs
Why do banks hold excess reserves?
Banks hold excess reserves for several reasons. Primarily, it's often due to central bank policies, such as quantitative easing, which injects significant liquidity into the banking system. Furthermore, central banks paying an interest rate on these holdings incentivizes banks to keep funds at the central bank rather than lending them out, especially if other investment opportunities offer lower returns or higher risk. Banks may also hold excess reserves as a precautionary measure during times of financial crisis or economic uncertainty to ensure ample liquidity.
How do excess reserves impact the money supply?
In a traditional banking system without interest on reserves, high excess reserves could lead to an expansion of the money supply as banks lend out these funds, creating new deposits through the money multiplier effect. However, when central banks pay interest on excess reserves, banks may choose to hold these funds instead of lending them, which can temper the expansion of the money supply even when reserves are abundant. This allows the central bank to control short-term interest rates more effectively.
Are excess reserves a sign of a strong or weak economy?
The interpretation of excess reserves depends on the context. In normal times, a low level of excess reserves might suggest that banks are actively lending and the economy is robust. However, a high level of excess reserves, particularly after periods of quantitative easing or during a financial crisis, can indicate that central banks are injecting liquidity to stabilize markets or stimulate economic growth. It can also reflect a lack of profitable lending opportunities or increased risk aversion among banks. Therefore, simply looking at the level of excess reserves without considering the broader monetary policy and economic environment can be misleading.