Reserve balances

What Are Reserve Balances?

Reserve balances refer to the funds that commercial banks hold in their accounts at a central bank, such as the Federal Reserve in the United States. These balances are a critical component of the broader financial system and play a key role in the execution of monetary policy. Historically, reserve balances were primarily held to satisfy regulatory required reserves, but in modern central banking frameworks, they often represent significant excess liquidity that banks maintain for various operational and strategic reasons.

History and Origin

The concept of banks holding reserves dates back to the early 19th century, with initial practices driven by the need to cover sudden withdrawals and ensure the convertibility of banknotes. Early national legislation, such as the National Bank Act of 1863 in the United States, imposed explicit reserve requirements on banks. These requirements mandated that banks hold a certain fraction of their deposit liabilities as reserves, either as vault cash or deposits at a central bank.¹⁵,¹⁴

The establishment of the Federal Reserve System in 1913 significantly centralized the holding of reserve balances. While originally intended to ensure bank liquidity and restrain credit expansion, the effectiveness of reserve requirements for these purposes evolved over time.¹³ A major shift occurred with the Emergency Economic Stabilization Act of 2008, which advanced the authority for the Federal Reserve to pay interest on reserve balances (IORB) to October 1, 2008.¹²,¹¹ This change allowed the Fed to manage short-term interest rates more effectively by influencing the rate at which banks lend to each other overnight, rather than relying solely on the quantity of reserves. In response to the COVID-19 pandemic, the Federal Reserve reduced reserve requirement ratios to zero percent, effective March 26, 2020, eliminating all formal reserve requirements for depository institutions.,¹⁰ Despite this, reserve balances continue to be held by banks, primarily due to large-scale asset purchases by the central bank, such as through quantitative easing.⁹,⁸

Key Takeaways

• Reserve balances are funds held by commercial banks in their accounts at a central bank.
• They are a primary liability on the central bank's balance sheet and a key tool for monetary policy implementation.
• Historically tied to required reserves, their role has shifted, especially since the introduction of interest on reserve balances and the elimination of reserve requirements in the U.S.
• High levels of reserve balances can result from central bank actions like quantitative easing, influencing overall liquidity in the financial system.
• The interest rate paid on reserve balances is a critical tool for central banks to manage short-term interest rates and influence credit conditions.

Formula and Calculation

While there isn't a singular "formula" for reserve balances themselves, their calculation for the purpose of interest payments is straightforward. Prior to July 29, 2021, the Federal Reserve paid interest on required reserves (IORR) and interest on excess reserves (IOER). Since that date, these two rates were replaced with a single Interest on Reserve Balances (IORB) rate.⁷,⁶

The interest paid on reserve balances is calculated daily:

At the end of a maintenance period (typically 14 consecutive days), the daily interest amounts are summed and credited to the depository institution's account.⁵,⁴ The total volume of reserve balances held by depository institutions can be tracked through data provided by the St. Louis Federal Reserve.

Interpreting Reserve Balances

The level of reserve balances held by banks is an important indicator of the banking system's overall liquidity and the stance of monetary policy. A high and stable level of reserve balances indicates that the financial system has ample liquidity, reducing the need for banks to borrow from each other in the interbank market. This "ample reserves" framework, adopted by many central banks, allows them to influence short-term market rates primarily through the interest paid on reserve balances, rather than through fine-tuning the supply of reserves via open market operations.³

Conversely, a low or declining level of reserve balances might signal tighter monetary conditions or potential liquidity shortages, prompting banks to seek funds more actively. Central banks monitor reserve balances closely as part of their efforts to maintain financial stability and achieve their macroeconomic objectives, such as price stability and maximum employment.

Hypothetical Example

Imagine "Green Valley Bank" holds an account with the Federal Reserve. At the end of a particular day, Green Valley Bank has a total of $500 million in its reserve balance account. If the Federal Reserve Board has set the Interest on Reserve Balances (IORB) rate at 5.5% annually, Green Valley Bank's daily interest earnings would be calculated as:

This daily interest accrues, and the total amount for the maintenance period is then paid to the bank. This income contributes to the bank's profitability and incentivizes it to hold these balances. The sheer volume of reserve balances held across the banking system reflects the aggregate liquidity available to all depository institutions in the economy.

Practical Applications

Reserve balances are fundamental to how modern central banks implement monetary policy. With the elimination of formal reserve requirements, central banks primarily use the interest rate paid on reserve balances as their main tool to steer the federal funds rate and influence other short-term interest rates in the economy. By adjusting the IORB rate, the central bank can encourage or discourage banks from lending their excess funds, thereby influencing credit conditions and, ultimately, economic growth and inflation.

Furthermore, large reserve balances are a direct result of unconventional monetary policy tools like quantitative easing (QE), where the central bank purchases vast amounts of government bonds and other assets. These purchases inject liquidity into the banking system, increasing banks' reserve balances.², This mechanism helps to lower long-term interest rates and stimulate economic activity, especially when short-term rates are already near zero. The impact of such policies on reserve balances and the central bank's overall balance sheet is closely monitored by financial analysts.

Limitations and Criticisms

While reserve balances are a powerful monetary policy tool, their large-scale accumulation, particularly during periods of extensive quantitative easing, has led to some criticisms and potential limitations. One concern is the impact on the central bank's profitability, as interest payments on substantial reserve balances can reduce remittances to the treasury, especially if market interest rates rise significantly.¹

Another point of discussion revolves around the effectiveness of transmitting policy signals when reserve balances are exceptionally high. In an environment of "ample reserves," changes in the interest rate paid on reserve balances might not always translate perfectly or immediately into desired changes in broader lending and economic activity. Critics also point to the potential for excessive liquidity to contribute to asset price bubbles or inefficient allocation of capital, though this is a subject of ongoing debate among economists. The historical shift away from strict required reserves means that reserve balances no longer serve their original purpose of ensuring bank-specific liquidity, as a central bank now functions as the primary backstop for systemic liquidity needs. The Federal Reserve Bank Services offers further details on current reserve administration practices.

Reserve Balances vs. Excess Reserves

The terms "reserve balances" and "excess reserves" are closely related and can often be a source of confusion, especially given recent changes in central bank policy.

Historically, reserve balances were composed of two parts:

1. Required Reserves: The minimum amount of funds that banks were legally obligated to hold, typically a percentage of their deposit liabilities.
2. Excess Reserves: Any funds held by banks at the central bank beyond their required reserves.

However, since March 2020, the Federal Reserve set the reserve requirement ratio to zero. This means that all reserve balances held by banks at the Federal Reserve are now, by definition, considered excess reserves. Therefore, in the current U.S. context, the terms "reserve balances" and "excess reserves" are effectively interchangeable, as there are no longer any legally mandated "required" portions. This framework allows the Federal Reserve to manage monetary policy primarily through the interest rate it pays on these balances, rather than through adjusting the quantity of reserves to meet a specific requirement.

FAQs

How do reserve balances affect the money supply?

When the central bank increases reserve balances, typically through asset purchases like quantitative easing, it injects liquidity into the banking system. While this directly increases the money held by banks, the broader effect on the money supply depends on how much of that liquidity banks choose to lend out to businesses and consumers.

Do banks earn interest on reserve balances?

Yes, in many major economies, including the United States, central banks pay interest rates on the reserve balances that commercial banks hold with them. This rate, known as the Interest on Reserve Balances (IORB) rate in the U.S., is a key tool for influencing short-term market rates and overall credit conditions.

What is the primary purpose of holding reserve balances today?

Currently, with zero required reserves in the U.S., the primary purpose of reserve balances is operational liquidity and as a reflection of the central bank's asset purchase programs. Banks hold these balances to facilitate payments and settlements, manage their own liquidity needs, and because they are compensated for doing so by the central bank. The level of these balances is a key indicator of the ample liquidity environment fostered by monetary policy.

How are reserve balances related to the Federal Reserve's balance sheet?

Reserve balances are a significant liability on the Federal Reserve's balance sheet. When the Federal Reserve buys assets (like Treasury securities or mortgage-backed securities) to implement monetary policy, it pays for these assets by crediting the reserve accounts of commercial banks, thereby increasing reserve balances on its liability side. Conversely, when the Federal Reserve reduces its asset holdings (quantitative tightening), reserve balances decrease.