Excess ReservesReserves in excess of the reserve requirement

When we talk of banks, what immediately comes to mind?

If your answer is “a bank is a place where you put your cash in”, you would be right.

Banks, among other financial institutions, are places where you can deposit your money.

Aside from that, banks are among financial institutions where individuals and businesses can borrow money.

You can say that a bank is a place where money rolls around.

Aside from depositing your cash, you can also withdraw your deposited cash.

Though nowadays, anyone with a debit card can withdraw their deposits from an ATM.

But for large amounts of cash withdrawals, a personal visit to the bank may be needed.

Given that anyone who has a deposit in a bank can withdraw cash from it anytime, the bank must always have a minimum amount of cash within its reach.

We refer to this as the bank’s reserves. A country’s central bank may require a minimum amount of reserves.

In the US, the reserve requirement ratio was recently reduced to 0% in response to the COVID-19 pandemic.

This means that banks within the US no longer have to maintain a certain amount of reserves.

So what if a bank has reserves that exceed the standard reserve requirement?

That’s when a bank has excess reserves.

In this article, we will be exploring what excess reserves are.

What does it mean for a bank or financial institution to have excess reserves?

Why would a bank or financial institution want to have excess reserves?

Let’s find out as we go along with the article.

What are Excess Reserves?

Excess reserves refer to a bank or financial institution’s capital reserves in excess of the reserve requirements.

For commercial banks, it is the country’s central bank that set the reserve requirement amounts.

In the US, it is the Federal Reserve that acts as the country’s central bank.

To calculate a bank or financial institution’s excess reserves, we simply have to deduct the required reserves from the amount of reserves that it holds.

Another name for excess reserves is “secondary reserves”.

Provided that a bank or financial institution doesn’t have borrowed reserves, all of its excess reserves are free reserves.

The funds for loans that a bank or financial institution extends to its borrower often come from its free reserves.

One of the reasons why a bank or financial institution would want to have excess reserves is to have an additional safety net for unexpected loan losses or large cash withdrawals.

However, holding excess reserves can also lead to an opportunity cost. For example, a bank may earn more if it invests its excess cash in more profitable investments rather than holding them.

Understanding Excess Reserves

Financial institutions, including banks, are typically required by their country’s central bank to hold a minimum amount of reserve.

This is to ensure that they have enough liquidity to cater to all cash withdrawals under normal circumstances.

Usually, the reserve requirement is a percentage of the deposit liabilities that the bank hold.

For example, let’s say that the reserve requirement is 10%.

A bank has $1,000,000 in total deposit liabilities.

This means that the bank needs to have at least $100,000 in reserves to comply with the reserve requirement.

A bank’s reserves usually consist of all its cash holdings plus its deposits with the central bank.

Most banks would just comply with the reserve requirement.

However, prudent banks may want to hold an additional amount of reserves.

This is so they can have an additional safety net for unexpected events, such as huge loan losses or large cash withdrawals.

Since this additional amount of reserves are in excess of the reserve requirement, we properly refer to them as excess reserves.

Since excess reserves provide extra liquidity and safety, a bank or financial can earn a higher credit rating by simply having them.

Higher excess reserves may also lead to an even higher credit rating.

However, having higher excess reserves can also lead to high opportunity costs.

For example, that bank or financial institution could earn more if it invests its excess reserves in high-return investment.

As such, having too many excess reserves isn’t ideal.

In the US, the Federal Reserve has to power to pay interest on excess reserves.

This provides an additional incentive for banks to hold excess reserves.

Interest on Excess Reserves (IOER)

Before 2008, banks in the US didn’t have any incentive to hold excess reserves other than the extra liquidity and security.

This is because banks in the US didn’t get paid any interest for holding excess reserves.

However, the Financial Services Regulatory Act of 2006 authorized the Federal Reserve to pay banks a rate of interest, which included interest on excess reserves.

It was supposed to go into effect on October 1, 2011.

However, the Great Depression necessitated the early enactment of the decision.

As such, as of October 1, 2008, the Federal Reserve is required to pay interest to banks in the US , and that includes interest on excess reserves (IOER).

From then on, banks have an additional incentive to hold excess reserves.

The IOER is also beneficial for the Federal Reserve.

With its introduction, the Federal Reserve gains another tool of monetary policy.

By raising the IOER rate, banks become more inclined to hold excess reserves.

This ultimately results in a reduction in the money supply as banks are more likely to hold them.

On the other hand, if the Federal Reserve wants to increase the money supply, it can reduce the IOER rate.

With a lower IOER rate, banks have lesser incentives to hold extra reserves. As such, banks are more likely to loan out their excess reserves.

Thus, a lower IOER may lead to an increase in the money supply.

Interest on reserves, including excess reserves, are typically paid out in cash.

They are recorded as interest on the part of the bank that receives it.

Excess Reserves vs Free Reserves

A bank’s excess reserves may contain two types of reserves: free reserves and borrowed reserves.

Free reserves refer to the portion of excess reserves that the bank can freely lend out.

A higher amount of excess reserves doesn’t necessarily mean a higher amount of free reserves.

That can only be true if the bank doesn’t have any borrowed reserves. In such a case, free reserves equal excess reserves.